What type of risk does diversification specifically aim to mitigate?

Diversification specifically aims to mitigate unsystematic risk, which refers to the risk inherent to a particular company or industry. This type of risk is unique to a specific asset or group of assets and can be reduced or eliminated through diversification. When an investor spreads investments across various assets, sectors, or industries, the negative performance of any single investment is less impactful on the overall portfolio, as other investments may perform well.

By holding a diversified portfolio, investors are less exposed to the factors that affect individual companies or sectors, such as management decisions, product recalls, or regulatory changes. This approach targets the idiosyncratic risks that impact specific securities rather than the broader changes in the market or economy.

In contrast, systematic risk, which includes factors like economic recessions or interest rate changes, cannot effectively be mitigated through diversification. It affects the entire market and influences all investments to some extent. Market risk and credit risk also fall into categories that are not directly addressed by diversification strategies. Therefore, focusing on unsystematic risk is crucial when discussing the benefits of diversifying an investment portfolio.