What type of risk can be eliminated by diversification?

Diversification is a key investment strategy utilized to mitigate risk, specifically unsystematic risk. Unsystematic risk is the type of risk that is unique to a particular company or industry, such as management decisions, product recalls, or competitive pressures. By spreading investments across a wide range of assets or sectors, investors can reduce the impact of any single investment's poor performance on their overall portfolio.

When a portfolio is diversified, the negative performance of one investment can be offset by the positive performance of others. This is because individual asset returns often have different reactions to the same market developments. Thus, the diversification strategy effectively eliminates unsystematic risk.

In contrast, systematic risk affects the entire market or a large segment of it and cannot be eliminated through diversification. This includes factors such as economic downturns, interest rate changes, or geopolitical events that impact all investments. Other types of risks, like interest rate risk and inflation risk, are also systematic in nature and similarly cannot be diversified away. Therefore, the understanding that diversification specifically targets unsystematic risk is a fundamental concept in investment strategy and financial planning.