NASAA Series 66 Uniform Combined State Law ExaminationEconomic Factors and Business InformationMedium
A portfolio manager is constructing a diversified portfolio for a client with a long-term investment horizon. To mitigate the impact of unexpected company-specific events, such as a product recall or a sudden change in management, which type of risk should the manager primarily focus on reducing through diversification?
- APurchasing power risk.
- BSystematic risk.
- CNonsystematic risk.
- DRegulatory risk.
Show answer & explanationAnswer & explanation
Correct answer: C. Nonsystematic risk.
Nonsystematic risk (also known as specific risk or diversifiable risk) is company-specific risk that can be reduced or eliminated through diversification. Events like product recalls or management changes are examples of nonsystematic risk.
Why the other options are wrong
- A. Purchasing power risk (inflation risk) is the risk that inflation erodes returns, which is not the focus of company-specific events.
- B. Systematic risk (market risk) affects the entire market and cannot be diversified away.
- D. Regulatory risk is the risk of changes in laws or regulations, which can be systematic or nonsystematic depending on scope, but the described events are more clearly company-specific nonsystematic risk.
Nonsystematic Risk (Diversifiable Risk)
Risk that is unique to a specific company or industry and can be reduced or eliminated by holding a diversified portfolio.
- Also called specific risk or unsystematic risk.
- Examples: product recalls, labor strikes, management changes.
- Can be mitigated through diversification.
Memory trick: Nonsystematic: Niche, Narrow, Neutralized by New Holdings.