Financial Industry Regulatory Authority (FINRA) Practice Exam 2025 - Free FINRA Practice Questions and Study Guide

Portfolio diversification is a strategy used to reduce risk by spreading investments across various assets, thereby minimizing the impact of any single investment's poor performance on the overall portfolio. Among the types of risks listed, business risk is specifically associated with a company’s performance and the potential for loss due to factors affecting its operations, such as management decisions, product reliability, and industry conditions.

By diversifying, an investor can hold shares in multiple companies across different sectors, which means that a downturn in one particular business will likely be offset by the performance of others in the portfolio. This reduces the overall exposure to business-specific risks because the event impacting one company may not affect others in the same way.

While other risks like inflation risk, interest-rate risk, and market risk can also be mitigated to some extent through strategic investing, they are not mitigated through diversification alone. For example, inflation risk affects all assets when prices rise, and interest rate risk impacts bond prices uniformly. Market risk, which relates to declines in the overall market affecting most stocks, cannot be diversified away either, as it pertains to the entire market's behavior. Thus, the focus on business risk illustrates how effective diversification can enhance an investor's risk management strategy.