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CMA Intermediate · Financial Management and Business Data Analytics · Risk and Return

As more randomly chosen stocks are added to a well-diversified portfolio, which risk is reduced and which remains?

Diversification reduces unsystematic risk, which is specific to individual firms, while systematic risk remains. Firm-specific shocks tend to offset each other across many stocks, but market-wide factors such as interest rates or economic cycles affect all securities and cannot be removed by diversification.

  1. ASystematic risk is eliminated; unsystematic risk remains
  2. BUnsystematic risk is reduced; systematic risk remainsCorrect
  3. CBoth risks are eliminated equally
  4. DNeither risk changes

Explanation

Diversification averages out firm-specific (unsystematic) risk because individual shocks offset. Market-wide (systematic) risk affects all securities and cannot be diversified away. The first option reverses the two.

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