What is diversification's effect on systematic risk?

Diversification plays a crucial role in risk management within a portfolio, particularly in relation to unsystematic risk. The correct understanding is that diversification reduces unsystematic risk, which is the type of risk that affects individual securities or industries and can be mitigated through careful selection and combination of assets. By spreading investments across various assets, such as stocks in different sectors or geographies, the unique risks associated with individual securities cancel each other out to some extent.

However, systematic risk, which is the inherent risk that affects the entire market or economy (e.g., macroeconomic factors, interest rates, economic downturns), cannot be eliminated through diversification. This risk is associated with market-wide phenomena that impact all securities to some degree, so no matter how diversified a portfolio may be, it remains exposed to systematic risk.

Therefore, diversification is effective in reducing overall portfolio risk by lowering unsystematic risk, but it does not have an impact on systematic risk, making the assertion that it reduces unsystematic risk but does not affect systematic risk the correct choice.