A client's brokerage statement reflects a noticeable drop in total valuation following a sudden macroeconomic adjustment that triggered a broad sell-off across all equities. The client's portfolio is spread evenly across thirty well-established companies in different industries. Which of the following statements correctly explains why portfolio diversification did not prevent this decline?
- The portfolio was impacted by market risk, a form of systematic risk that affects the entire financial system and cannot be diversified away.Answer
- BThe portfolio was impacted by nonsystematic risk, which could have been eliminated entirely by adding ten more domestic equity positions.
- CThe portfolio was impacted by credit risk, which occurs when issuing corporations fail to make timely dividend payments.
- DThe portfolio was impacted by interest rate risk, which causes stock market prices to rise in direct proportion to benchmark interest rate increases.
Answer
The decline was caused by market risk, which is a systematic risk factor that impacts the broad market and cannot be mitigated through asset diversification alone.
Market risk is a primary subtype of systematic risk. Because systematic risk stems from broad economic events affecting the entire market, constructing a diversified equity portfolio does not protect an investor from broad market downturns.
Step-by-Step Solution
Key Concept
Systematic risk (market risk) affects the overall market and cannot be eliminated through portfolio diversification.