What concept reduces risk by replacing a single risk with many smaller unrelated risks?

• A. Insurance
• B. Hedging
• C. Risk pooling
• D. Diversification

Answer: (D)

Diversification reduces risk by replacing a single exposure with many investments whose returns aren’t perfectly correlated. When some assets stumble, others may hold steady or rise, so the overall portfolio volatility decreases. This mainly cuts unsystematic risk—the risk tied to individual investments—while market-wide factors (systematic risk) still affect the portfolio. The other approaches don’t achieve this same spread of risk: insurance shifts risk to an insurer, hedging offsets potential losses with derivatives, and risk pooling shares risk among participants rather than building a diversified mix of unrelated assets to dampen overall fluctuations.