Final answer:
It is true that diversification through only stocks is limited since many stocks are influenced by similar market conditions. To achieve better diversification, investing in mutual funds, particularly index funds, is beneficial as they mimic the stock market's overall performance.
Step-by-step explanation:
The statement that diversification by investing only in stocks is limited is true. This is because many stocks are influenced by the same broad market conditions, such as economic growth rates, interest rate trends, and geopolitical events. Therefore, investing in a mutual fund, especially an index fund, can help in diversifying your investment portfolio. Index funds aim to imitate the overall behavior of the stock market, offering a broader diversification compared to investing in individual stocks alone.
While diversification in stocks can reduce unsystematic risk related to individual companies, it does not eliminate systematic risk associated with the market as a whole. To further diversify, investors can invest in a variety of asset classes beyond stocks, such as bonds, real estate, and commodities. Following the principle of "Don't put all your eggs in one basket," investors mitigate the risk of their investment portfolio.