Which of the following statements best describes the primary benefit of diversification in a portfolio, according to Modern Portfolio Theory?

Question: Which of the following statements best describes the primary benefit of diversification in a portfolio, according to Modern Portfolio Theory?

Answer options:

• It guarantees higher returns by selecting only top-performing assets.
• It eliminates all investment risk, including market risk. ✅ It reduces specific (unsystematic) risk without sacrificing expected return.
• It ensures that a portfolio will always outperform the market index.

Correct answer: It reduces specific (unsystematic) risk without sacrificing expected return.

Explanation: Diversification primarily reduces specific (unsystematic) risk by combining assets with different return patterns. It cannot eliminate systematic (market) risk, nor does it guarantee superior returns or the elimination of all risk.