CFA Level IPortfolio ManagementEasy
A portfolio manager gradually increases the number of holdings in a portfolio from 10 stocks toward a broadly diversified market portfolio. As the number of holdings grows, which type of risk is progressively eliminated, and which type remains?
- AUnsystematic risk is eliminated; systematic (market) risk remains and cannot be diversified away.
- BTotal risk increases steadily as more securities are added due to added complexity.
- CSystematic risk is eliminated; unsystematic risk remains and cannot be diversified away.
- DBoth systematic and unsystematic risk are eliminated completely as holdings increase.
Show answer & explanationAnswer & explanation
Correct answer: A. Unsystematic risk is eliminated; systematic (market) risk remains and cannot be diversified away.
Diversification reduces firm-specific (unsystematic) risk because idiosyncratic events across different companies tend to offset each other. Market-wide (systematic) risk, driven by macroeconomic factors affecting all securities, cannot be eliminated through diversification and is the only risk priced under CAPM.
Why the other options are wrong
- B. Diversification reduces, not increases, total risk (up to the systematic risk floor).
- C. This reverses the relationship; systematic risk is the risk that remains, not the one removed.
- D. Systematic risk always remains regardless of diversification.
Diversifiable vs. Non-diversifiable Risk
Unsystematic (firm-specific) risk can be eliminated through diversification; systematic (market) risk cannot and is the only risk compensated with a risk premium.
- Total risk = systematic + unsystematic risk
- Adding uncorrelated securities reduces unsystematic risk toward zero
- CAPM prices only systematic risk (beta)
Memory trick: Don't put all eggs in one basket — but the whole market still shakes.