A retail investor holds a portfolio containing common stocks of 50 major U.S. corporations spread across ten different industry sectors. Following a sudden macroeconomic shift and interest rate hike, market prices decline across nearly all equity sectors. Which of the following statements correctly explains why diversifying across 50 different stocks did not protect the portfolio from this decline?
- Diversification reduces unsystematic (business-specific) risk, but market risk is a systematic risk that affects the entire equity market and cannot be eliminated through diversification.Answer
- BDiversification completely eliminates market risk, but the portfolio experienced losses because equities lack protection against issuer credit defaults.
- CThe loss occurred because rising interest rates cause prevailing bond yields to fall, which automatically lowers stock valuation metrics across all sectors.
- DMonetary policy adjustments by Congress alter federal tax rates, which directly triggers unsystematic credit defaults across corporate issuers.
Answer
Diversification reduces unsystematic (business-specific) risk, but market risk is a systematic risk that affects the entire equity market and cannot be eliminated through diversification.
Diversification is an effective strategy for reducing unsystematic (business-specific) risk by spreading investment across multiple issuers and sectors. However, market risk is a systematic risk caused by broad macroeconomic forces such as interest rate changes, inflation, or geopolitical events. Because systematic risk affects the market as a whole, it cannot be eliminated through asset diversification.
Step-by-Step Solution
Key Concept
Systematic Risk vs. Unsystematic Risk and the Limits of Diversification
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