A retail investor maintains a portfolio that is broadly diversified across dozens of domestic stocks spanning all major economic sectors. Following an unexpected announcement of macroeconomic rate hikes by the Federal Reserve, the entire equity market experiences a sharp decline, causing the value of the investor's portfolio to fall. Which of the following statements best explains why diversification did not prevent this portfolio loss?
- Interest rate changes represent a systematic risk that impacts the overall market and cannot be eliminated through asset diversification.Answer
- BAdding stocks from additional industry sectors would have eliminated the loss, as systematic risk only impacts concentrated portfolios.
- CThe portfolio decline was primarily driven by issuer default risk, which automatically increases for equity securities when prevailing interest rates rise.
- DThe loss occurred because an inverted yield curve guarantees immediate price drops across all equity securities regardless of economic conditions.
Answer
Interest rate changes represent a systematic risk that impacts the overall market and cannot be eliminated through asset diversification.
Interest rate changes and general market downturns are core examples of systematic risk. Systematic risk stems from macro-level economic factors that influence the market as a whole, meaning it affects virtually all equity holdings regardless of how well diversified the portfolio is across sectors.
Step-by-Step Solution
Key Concept
Systematic risk (market risk, interest rate risk) affects the broad market and cannot be avoided through portfolio diversification.