Final answer:
Diversification is an investment strategy that minimizes company-specific risk by spreading investments across various entities. However, it doesn't significantly reduce purchasing power risk, as this type of risk is related to inflation affecting the overall market.
Step-by-step explanation:
Diversification in investing refers to the strategy of spreading investments across various financial instruments, industries, and other categories to minimize risk. One type of risk that diversification greatly reduces is company-specific risk, also known as unsystematic risk. This risk is specific to an individual company or industry and can result from events such as managerial errors, product recalls, or regulatory changes that may negatively impact the company's stock price.
Diversification does not, however, eliminate all types of risk. It has little effect on systematic risk, which is the risk inherent to the entire market or market segment. Systematic risk includes interest rate changes, political instability, or inflation, which are not reduced by diversification. Also, diversification does not directly address purchasing power risk, which is the risk that inflation erodes the buying power of money, potentially affecting all investments broadly.
To address purchasing power risk, investors often look to assets that have historically outpaced inflation, such as equities or inflation-protected securities, rather than relying solely on diversification.