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Question

Difficulty: MediumSystematic and Market Risks

An investor holds a portfolio of 500 individual U.S. common stocks broadly diversified across all major economic sectors. Following an unexpected macroeconomic announcement, the broader equity market experiences a sharp decline, causing the investor's portfolio value to decrease by a similar percentage. Which of the following best explains why extensive asset diversification failed to prevent this loss?

  1. Diversification mitigates company-specific unsystematic risk, but cannot eliminate systematic market risk that impacts the entire financial system.Answer
  2. B
    Holding a large number of individual equity holdings converts unsystematic risk into systematic risk due to portfolio dilution.
  3. C
    Market-wide price drops are driven primarily by credit default events, which can only be avoided by purchasing high-grade securities.
  4. D
    Systematic risk would have been completely avoided if the investor had allocated the portfolio into long-term fixed-rate corporate bonds.

Answer

Diversification mitigates company-specific unsystematic risk, but cannot eliminate systematic market risk that impacts the entire financial system.
Broad diversification across issuers and industry sectors neutralizes company-specific (unsystematic) risk. However, systematic risk—such as general market risk driven by macroeconomic events—affects the market as a whole and cannot be eliminated through asset diversification.

Step-by-Step Solution

1
Identify the nature of the risk causing the portfolio decline.
The drop was triggered by a broad macroeconomic shock that lowered values across the entire stock market, which defines systematic (market) risk.
Systematic risks originate from economy-wide events—such as interest rate changes, recessions, or geopolitical shocks—that affect all market participants simultaneously.
2
Evaluate the structural limitations of portfolio diversification.
Spreading investment across 500 stocks removes unsystematic (issuer-specific) risk, but cannot shield the portfolio against market-wide systematic risk.
Because systematic risk is inherent to the financial market as a whole, holding a broad basket of equities remains subject to general market downturns.

Key Concept

Limits of Portfolio Diversification on Systematic Risk
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Topics

Systematic and Market Risks

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