All of the following statements are true EXCEPT:
An investor can eliminate virtually all systematic risk if he or she holds a very large and well diversified portfolio of stocks.
An investor can eliminate virtually all company-specific risk if he or she holds a very large, well-diversified portfolio of stocks.
The required rate of return for an asset is equal to the risk-free rate plus a risk premium.
The higher the correlation between the stocks in a portfolio, the greater the risk inherent in the portfolio.
The Correct Answer and Explanation is :
Correct Answer:
“An investor can eliminate virtually all systematic risk if he or she holds a very large and well-diversified portfolio of stocks.”
Explanation:
Systematic risk, also known as market risk, is the risk that affects the entire market and cannot be eliminated through diversification. It includes risks such as economic downturns, inflation, interest rate changes, political instability, and global financial crises. Even with a highly diversified portfolio, an investor remains exposed to systematic risk because it impacts all securities to some degree.
On the other hand, company-specific risk (also called unsystematic risk or idiosyncratic risk) is unique to a particular company or industry and can be significantly reduced or even eliminated through diversification. For example, factors such as poor management decisions, product failures, or legal troubles are specific to individual companies and do not affect the entire market. By holding a large number of different stocks from various industries, an investor can minimize the impact of these individual risks.
The other statements are correct:
- An investor can eliminate virtually all company-specific risk with a well-diversified portfolio. This is true because unsystematic risk can be diversified away by investing in multiple companies across different industries.
- The required rate of return for an asset is equal to the risk-free rate plus a risk premium. This follows the Capital Asset Pricing Model (CAPM), which states that the expected return on an asset is determined by adding a risk premium (based on beta) to the risk-free rate.
- The higher the correlation between stocks in a portfolio, the greater the risk inherent in the portfolio. When stocks are highly correlated, they tend to move together, reducing the benefits of diversification.
Thus, the incorrect statement is the first one, as systematic risk cannot be fully eliminated.