Which statement best describes the effect of diversification on risk types?

Which statement best describes the effect of diversification on risk types?

• A. Systematic risk cannot be diversified away, but unsystematic risk can.
• B. Systematic risk can be diversified away; unsystematic cannot.
• C. Both can be eliminated with enough diversification.
• D. Neither can be managed.

Answer: (A)

Diversification works by spreading investments across many assets, which helps cancel out the unique risks tied to any one company or industry. That type of risk—unsystematic (idiosyncratic) risk—can be largely eliminated with a well-diversified portfolio because the fortunes of different securities don’t move perfectly together. But systematic (market) risk comes from broad factors that affect the entire market—things like economic cycles, interest rates, or inflation. These influences impact nearly all assets, so diversification can’t remove them. You can adjust your mix to manage exposure to those forces, but you can’t eliminate the risk through diversification alone. So the statement that best fits is that systematic risk cannot be diversified away, while unsystematic risk can be.

Diversification works by spreading investments across many assets, which helps cancel out the unique risks tied to any one company or industry. That type of risk—unsystematic (idiosyncratic) risk—can be largely eliminated with a well-diversified portfolio because the fortunes of different securities don’t move perfectly together.

But systematic (market) risk comes from broad factors that affect the entire market—things like economic cycles, interest rates, or inflation. These influences impact nearly all assets, so diversification can’t remove them. You can adjust your mix to manage exposure to those forces, but you can’t eliminate the risk through diversification alone.

So the statement that best fits is that systematic risk cannot be diversified away, while unsystematic risk can be.