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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

A portfolio manager holds a diversified equity portfolio and is concerned only about one company's stock, which represents a small part of the portfolio. Which statement best describes why diversification reduces risk for this investor?

Diversification reduces idiosyncratic (firm-specific) risk because shocks to individual holdings are imperfectly correlated and partly offset one another. It cannot remove systematic market risk. Transferring losses for a premium is insurance, not diversification.

  1. AIt eliminates systematic risk by combining assets from different sectors
  2. BIt reduces idiosyncratic risk because firm-specific shocks are imperfectly correlated across holdingsCorrect
  3. CIt raises expected return without changing portfolio volatility
  4. DIt transfers losses to a third party in exchange for a premium

Explanation

Diversification works because firm-specific shocks are not perfectly correlated, so they partly offset each other in a portfolio. Systematic risk remains, which is why the first option is wrong. Option four describes insurance, not diversification.

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