A retail investor holds an equity portfolio broadly diversified across 300 individual stocks spanning ten separate industry sectors. Following a major macroeconomic shock that drives up interest rates and broad market volatility, nearly all positions in the portfolio experience downward price movement at the same time. Which of the following statements correctly explains why diversification failed to protect the portfolio from this downturn?
- Diversification eliminates non-systematic risk, but market risk affects the entire financial market and cannot be diversified away.Answer
- BThe portfolio was improperly constructed because spreading capital across 300 stocks converts systematic risk into non-systematic risk.
- CThe simultaneous decline occurred because rising benchmark interest rates increase default risk for large corporate equity issuers.
- DBroad macroeconomic downturns associated with rising rates signal an inverted yield curve, which guarantees economic expansion and short-term stock revaluation.
Answer
Diversification eliminates non-systematic risk, but market risk affects the entire financial market and cannot be diversified away.
Systematic risk, such as market risk, is driven by broad macroeconomic forces like interest rate changes and market-wide volatility. Because these forces affect nearly all securities simultaneously, systematic risk cannot be eliminated through diversification regardless of how many positions are held.
Step-by-Step Solution
Key Concept
Systematic risk (market risk) affects the broader market and cannot be eliminated through portfolio diversification.
Estimated Time:1m 30s