Which risk can be reduced through diversification?

Unsystematic risk is the type of risk that can be reduced through diversification. This risk is specific to a particular company or industry and can arise from various factors, such as management decisions, operational issues, or changes in consumer preferences. By holding a diversified portfolio that includes a variety of assets across different sectors, industries, or geographic regions, an investor can mitigate the impact of any single asset's poor performance on the overall portfolio.

When one asset faces difficulties, others within the portfolio may perform well, thus balancing the overall risk. This is in contrast to systematic risk, which affects all investments in the market and cannot be eliminated through diversification. Systematic risk includes threats like economic downturns or changes in interest rates and affects a broader market or financial system.

Market risk and sector risk are also forms of systematic risk that cannot be diversified away. Market risk pertains to the overall fluctuations in the financial markets, while sector risk is related to a specific segment of the market, neither of which can be fully mitigated simply by diversifying the portfolio. Hence, diversification is most effective in reducing unsystematic risk.