Accredited Financial Counselor (AFC) Practice Exam

Diversification in investment refers to the strategy of spreading investments across various asset classes, such as stocks, bonds, real estate, or commodities. The primary objective of diversification is to reduce risk. By diversifying, an investor minimizes the impact of any single asset's poor performance on the overall portfolio.

For example, if an investor only holds stocks and the stock market experiences a downturn, the value of their portfolio can decrease significantly. However, by diversifying their investments to include different asset classes, the adverse effect of one underperforming asset can potentially be offset by the stability or gains from others. This strategy aims to create a more stable investment landscape over time, often leading to more consistent returns.

In contrast, options focusing on investing only in stocks, concentrating in a few high-yield stocks, or investing exclusively in bonds do not embody the principle of diversification. These strategies carry higher risks as they rely heavily on a single type of investment, thus exposing the investor to greater volatility and potential losses.