How does systematic risk differ from unsystematic risk in the way it can be reduced?
- ASystematic risk can be largely removed by holding a diversified portfolio of securities, while unsystematic risk affects the whole market and cannot be diversified away.
- BBoth systematic and unsystematic risk can be fully eliminated by holding a broadly diversified portfolio across many asset classes and geographies.
- CSystematic risk affects the entire market and cannot be eliminated through diversification, while unsystematic risk is specific to an issuer or sector and can be reduced by diversifying. Correct
- DSystematic risk applies only to individual bonds through credit downgrades, while unsystematic risk applies only to equities through price swings.
Why A is wrong: This is tempting because it uses the correct vocabulary of diversification, but it reverses the two concepts: diversification reduces unsystematic risk, not systematic risk, so the statement is wrong.
Why B is wrong: This appeals to the belief that enough diversification cures all risk, but systematic risk is inherent to the market as a whole and remains no matter how broadly a portfolio is spread, so the claim overstates diversification's power.
Why C is correct: Correct: systematic (market) risk stems from broad factors such as interest rates and recessions that move all securities together, so spreading holdings does not remove it, whereas unsystematic risk is company or sector specific and is reduced by diversification.
Why D is wrong: This is tempting because credit downgrades and price swings are real risks, but it misdefines both terms: systematic and unsystematic risk each apply across asset classes and are not split neatly between bonds and equities.