Diversification

An adviser recommends a concentrated position in one stock for a risk-averse client. This is:

1. A.Generally unsuitable; diversification is warrantedCorrect - concentration adds unnecessary risk.
2. B.Fine if the stock is popularPopularity does nothing to reduce the risk that a single issuer disappoints, and widely held names have produced some of the sharpest single-stock losses. What matters is the client's tolerance for that outcome, which the stem tells us is low.
3. C.Required by the prudent investor ruleThe prudent investor standard points the other way, treating diversification as the expected practice unless there is a specific reason not to diversify. This choice invokes a real rule but inverts what it requires.
4. D.Ideal for safetyConcentration raises rather than lowers the portfolio's exposure to company-specific events. Safety for a risk-averse client comes from spreading holdings so that no single issuer's failure can impair the whole account.

Why: Concentration is generally unsuitable for a risk-averse client; diversification is warranted.

Nonsystematic (specific) risk can be reduced primarily through:

1. A.Increasing leverageBorrowing magnifies whatever risk the portfolio already carries, including the security-specific risk the question asks about. Leverage scales exposure up rather than diluting it across issuers.
2. B.Market timingTiming entries and exits is aimed at market movements, which is systematic risk, and even there it is unreliable. It does nothing about the possibility that one company in the portfolio suffers a fraud, a recall, or a lost patent.
3. C.Concentrating in one stockThis is the definition of taking on specific risk rather than reducing it. A single-stock portfolio has no offsetting positions, so every issuer-level surprise passes straight through to the investor.
4. D.DiversificationCorrect - spreading holdings lowers specific risk.

Why: Diversification reduces security-specific, nonsystematic risk; it cannot eliminate market risk.

An agent tells a nervous prospect: "Spread your money across forty different companies in ten industries and you have eliminated your risk - a broad decline can no longer hurt you." The statement is:

1. A.accurate, because a portfolio of forty issuers across ten industries is large enough that individual outcomes offset one another completelyOffsetting individual outcomes is exactly the unsystematic risk that diversification removes. It leaves market risk untouched.
2. B.misleading, because diversification reduces unsystematic risk but does not eliminate systematic market riskCorrect. A broad decline still hits a well-diversified portfolio; only issuer-specific risk is diversified away.
3. C.accurate, provided none of the forty companies is in the same industry as anotherEven forty different industries do not remove market risk.
4. D.misleading only because forty holdings is too few; the statement would be accurate at roughly two hundred holdingsNo number of stock holdings eliminates systematic risk.

Why: Diversification addresses UNSYSTEMATIC risk - the risk attaching to a particular company, industry or issuer - and holding many unrelated positions does reduce it substantially. It does nothing about SYSTEMATIC or market risk, the risk that securities generally fall together in response to interest rates, recession, or a broad repricing of assets. In a market-wide decline a portfolio of forty stocks across ten industries falls too. Telling a prospect that diversification eliminates risk is a misstatement of a material fact, and the fact that it is a familiar piece of shorthand does not make it accurate.

Diversifiable risk is also known as:

1. A.Unsystematic (specific) riskCorrect - specific risk is diversifiable.
2. B.Systematic riskSystematic risk is defined by the fact that diversification cannot remove it, so it is the exact complement of what the question describes. Adding more securities does nothing to escape it.
3. C.Interest-rate riskWhen rates move, bonds across the market reprice together. Because a portfolio cannot spread its way out of that exposure, interest-rate risk belongs to the non-diversifiable side of the ledger.
4. D.Market riskMarket risk is simply another name for systematic risk, so this choice names the category the question is contrasting against. Diversifiable risk is what disappears as holdings multiply; market risk is what is left when they do.

Why: Diversifiable risk is unsystematic (company- or sector-specific) risk that diversification can reduce.