Which of the following is true of systematic risk?
a. It is less tightly linked to the market as a whole than unsystematic risk.
b. It cannot be diversified away by holding a pool of individual assets.
c. An investor can avoid this type of risk through calculated investment choices.
d. It does not require additional compensation in terms of expected return.
The Correct Answer and Explanation is :
The correct answer is b. It cannot be diversified away by holding a pool of individual assets.
Explanation:
Systematic risk, also known as market risk or non-diversifiable risk, refers to the portion of total risk that affects the entire market or economy. This risk is linked to factors that influence the overall market, such as economic downturns, changes in interest rates, inflation, and geopolitical events. Unlike unsystematic risk (or specific risk), which is unique to a particular company or industry and can be reduced or eliminated through diversification, systematic risk affects all assets in the market to some extent and cannot be eliminated by simply holding a diverse portfolio.
Key points:
- Cannot be diversified away: Systematic risk is inherent in the market and impacts all securities, regardless of the diversification of an investor’s portfolio. For example, during a broad market downturn, all stocks may decline in value to some extent, so diversification does not help eliminate this type of risk. It can only be mitigated through strategies like hedging or asset allocation to different asset classes (e.g., bonds, stocks, commodities) that behave differently under various market conditions.
- Market-wide impact: This type of risk is often driven by macroeconomic factors such as recessions, inflation, or major regulatory changes. These factors influence the entire market, and as a result, even the most diversified portfolio will still be subject to systematic risk.
- Increased expected returns as compensation: Investors typically demand higher returns for taking on systematic risk, as it is unavoidable and cannot be diversified away. This compensation is one reason why equity investments, which are subject to higher systematic risk, tend to offer higher returns over the long run compared to safer investments like bonds.
Incorrect options:
- a. Unsystematic risk is more tightly linked to specific companies, not the market as a whole.
- c. While calculated choices can reduce unsystematic risk, they cannot avoid systematic risk.
- d. Investors typically seek additional compensation for bearing systematic risk through higher expected returns.