An investor holding a domestic stock portfolio attempts to protect against market declines by reallocating capital equally across 200 individual companies spanning all eleven major economic sectors. During an unexpected macroeconomic contraction, broad equity indexes experience a 25% drop, and the investor's portfolio incurs a nearly identical decline. Which of the following statements best explains why this asset allocation strategy failed to protect the portfolio's market value?
- Diversification eliminates non-systematic (business-specific) risk, but cannot eliminate systematic market risk that influences the overall securities market.Answer
- BThe investor failed to eliminate market risk because true systematic protection requires spreading capital across a minimum of 1,000 individual issuers.
- CReallocating capital across fixed-income instruments of varying issuers would have rendered the portfolio completely immune to market price declines.
- DAn inverted yield curve during economic contractions automatically converts unsystematic risk into non-diversifiable risk for equity holdings.
Answer
Diversification eliminates non-systematic (business-specific) risk, but cannot eliminate systematic market risk that influences the overall securities market.
Systematic risk (also known as market risk) is driven by macroeconomic events that impact the entire financial system. Because systematic factors affect virtually all equity securities simultaneously, diversifying across 200 stocks or across all economic sectors cannot protect a portfolio against general market declines.
Step-by-Step Solution
Key Concept
Non-diversifiability of Systematic Risk
Estimated Time:1m 30s