Systematic Risk

Systematic risk is also known as:

1. A.Market (non-diversifiable) riskCorrect - it cannot be diversified away.
2. B.Business riskBusiness risk arises from how a particular company is run, its products, and its competitive position. Holding many companies dilutes it away, which places it in the unsystematic category rather than the systematic one.
3. C.Default riskDefault risk attaches to a single borrower failing to pay. Spreading holdings across many issuers reduces it substantially, and anything diversification can shrink is by definition not systematic.
4. D.Company-specific riskCompany-specific risk is the plain-language definition of unsystematic risk, the exact opposite of what the question asks for. Systematic risk is what remains after every company-specific factor has been diversified away.

Why: Systematic risk - market risk - is non-diversifiable and affects the whole market.

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.

Legislation changes the tax treatment of dividends for all taxpayers, and dividend-paying stocks across every industry fall. This exposure is best classified as:

1. A.Business risk, because the affected companies must now reconsider their payout policies.Wrong. Business risk concerns how well a particular firm runs its operations, not an alteration of the tax code.
2. B.Nonsystematic risk, because only companies that pay dividends were affected by the change.Wrong. The affected group spans every industry, so no amount of spreading across sectors avoids it.
3. C.Credit risk, because the change reduces the cash ultimately available to shareholders.Wrong. Credit risk concerns an issuer's ability to service its debts, which a dividend tax change does not determine.
4. D.Systematic risk, because a change in law reaches the entire market at the same time.Correct. Legislative and political risk is market-wide by nature and cannot be diversified away.

Why: Systematic risk covers the influences that move broad markets: interest rates, inflation, recession, war, and changes in law and regulation. A tax change applying to all dividend-paying shares reaches across industries, so a portfolio spread over many sectors is exposed just the same. Nonsystematic risk is tied to a particular issuer or a narrow group, which is why adding unrelated holdings dilutes it. Had the legislation targeted one industry alone, a broadly spread portfolio would have absorbed only a fraction of the impact.