Question

Diversification can eliminate:

a. all risk in a portfolio.

b. risk only if the investor is risk averse.

c. the systematic risk in a portfolio.

d. the idiosyncratic risk in a portfolio.

Answer 1

Ref. No. Date 1) Diversification can eliminate the idiosyncratic risk in a portfolio. (Option D is correct) while investing, one comes across two types of risk → Systematic or Market Risk → Unsystematic or Idiosyncratic Risk. Market risk is the risk which every investor has to accept because such risks are controlled by market forces which includes inflation rates, interest rates, political emergency, war etc. On the other hand, idiosyncratic risk is the type of risk which is applicable to individual entity and not the entire market, like stock of a particular company or group of companies. Here comes the role of diversification which aims to reduce risk by investing in various financial instruments which react differently to the same event and in this way risks are diversified. Diversification carit reduce all risks and is not profitable only to risk aversive person as we have seen earlier.