FRM Part II · FRM Exam Part II · Factors
An investor holds a portfolio of 40 stocks across many sectors and believes it is well diversified. During a market sell-off, the portfolio falls sharply along with equity value, size and momentum exposures that are all highly correlated with the equity market. What is the most appropriate conclusion?
Diversifying across many securities does not guarantee diversification across risk factors. If holdings share exposures to the same factors, such as equity market risk, they fall together in a sell-off, so risk should be assessed at the factor level rather than by counting positions.
- ADiversification by asset count does not ensure diversification by risk factors, since holdings may share common factor exposuresCorrect
- BAdding more stocks of the same type will eliminate the systematic risk
- CThe loss shows idiosyncratic risk was not diversified
- DFactor models cannot explain drawdowns in stress periods
Explanation
Holding many assets removes idiosyncratic risk but not common factor risk. If holdings load on the same factors, losses are concentrated in those factors, especially when correlations rise in stress. Adding similar stocks does not remove systematic risk.
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