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Difficulty: Very hardSystematic and Market Risks

An investor maintains a portfolio containing 50 individual U.S. large-cap equities spread across multiple industry sectors. Concerned about potential portfolio downturns driven by macroeconomic instability and unexpected interest rate increases, the investor asks a registered representative how further asset diversification will impact the account's overall exposure. Which of the following statements accurately evaluates the risk characteristics of this portfolio?

  1. Broad diversification effectively minimizes non-systematic risk, but the portfolio remains fully exposed to market and interest rate risks that cannot be eliminated by adding more equities.Answer
  2. B
    Expanding the portfolio to over 100 individual U.S. large-cap equities will eventually eliminate its systematic risk, fully protecting the account against market-wide downturns.
  3. C
    If prevailing interest rates rise unexpectedly, any high-grade corporate bonds added to the portfolio will gain market value, perfectly offsetting equity market losses.
  4. D
    If the yield curve becomes inverted, it signals rapid economic expansion, confirming that the systematic market risk for equity holdings is virtually non-existent.

Answer

Broad diversification minimizes non-systematic (company-specific) risk, but systematic risks such as market and interest rate risk affect the entire market and cannot be eliminated through diversification.
Diversification allows investors to reduce non-systematic (specific) risk by spreading investments across multiple companies and industries. However, systematic risk—which includes market risk and interest rate risk—is caused by broad economic factors affecting the entire market. Therefore, adding more equities to a portfolio cannot eliminate systematic risk.

Step-by-Step Solution

1
Identify the type of risks present in a diversified equity portfolio.
The portfolio holds 50 large-cap stocks across sectors, which substantially mitigates non-systematic (unsystematic/business) risk.
Spreading capital across multiple issuers reduces exposure to single-company events.
2
Evaluate the impact of diversification on systematic risk factors.
Systematic risks—such as market risk, inflation risk, and interest rate risk—stem from broad macroeconomic forces and affect all securities in the asset class.
Because systematic risk is market-wide, expanding asset count within the same asset class cannot remove systematic market exposure.
3
Select the option that correctly contrasts systematic vs. non-systematic risk.
The statement accurately noting that non-systematic risk is minimized while systematic risk remains unaffected by further stock diversification is correct.
This directly aligns with fundamental modern portfolio theory tested on the SIE exam.

Key Concept

Systematic risk (market risk) affects the entire market and cannot be eliminated through diversification, unlike non-systematic risk.
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Topics

Systematic and Market Risks

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