Why does diversification reduce risk?

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Why does diversification reduce risk?



Answer: The standard deviation of returns is generally higher on individual stocks than it is on the market. Because individual stocks do not move in lockstep, much of their risk can be diversified away. Stock returns are less than perfectly correlated. By spreading your portfolio accross many investments you smooth out the risk of your overall position. The risk that can be eliminated through diversification is known as unique risk.

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