NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesMedium
An investment adviser is counseling a client who is a small business owner. The client has significant personal assets tied up in their business and is concerned about the potential for their business to fail, impacting their personal finances. Which capital market theory concept best explains the risk this client is facing?
- ASystematic Risk (Market Risk)
- BUnsystematic Risk (Specific Risk)
- CModern Portfolio Theory (MPT)
- DEfficient Market Hypothesis (EMH)
Show answer & explanationAnswer & explanation
Correct answer: B. Unsystematic Risk (Specific Risk)
The client's concern about their specific business failing and impacting their personal finances relates to unsystematic risk, also known as specific risk or idiosyncratic risk. This is the risk inherent to a specific company or industry, which can be diversified away through a broad portfolio. Systematic risk, on the other hand, affects the entire market and cannot be diversified away.
Why the other options are wrong
- A. Systematic risk (market risk) is the risk that affects the entire market or economy, not just a single business, and cannot be diversified away.
- C. MPT focuses on constructing portfolios to maximize return for a given level of risk, but doesn't specifically name the risk of a single business failing.
- D. EMH suggests that all available information is reflected in asset prices, not directly related to the risk of a single business failure.
Unsystematic Risk
Also known as specific risk or idiosyncratic risk, it is the risk inherent to a specific company, industry, or asset, which can be reduced or eliminated through diversification.
- Unique to a particular investment.
- Examples: management changes, product recalls, company-specific lawsuits.
- Can be diversified away.
- Not correlated with overall market movements.
Memory trick: Risks: Some you can dodge, some you cannot avoid.