Ms Brown is reviewing her investment portfolio of Australian shares with her advisor. Which of the following statements best explains why investors are typically not compensated for taking on unsystematic risk?

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BlackTom AI · Accepted Answer

Question restated: Ms Brown and her advisor are evaluating why investors are typically not compensated for taking on unsystematic risk when investing in Australian shares.
Option a: 'Unsystematic risk can be reduced through diversification, so investors are not compensated for bearing it.' This matches core capital market theory: unsystematic (idiosyncratic) risk arises from factors specific to a single asset or small group of assets and can be mitigated by holding a diversified portfolio, so it does not command a risk premium. The logic is that diversification eliminates this risk, leaving only systematic risk to be priced.
Option b: 'Unsystematic risk is difficult to measure, so markets tend to ignore it in pricing.' This is not accurate. While measuring risk components can be nuanced, pricing is not primarily about measurement difficulty; it rests on the properties of diversification. The key point is that diversification reduces unsystematic risk, which is why it does not require compensation.
Option c: 'Unsystematic risk only applies to property and fixed income investments, not shares.' This statement is incorrect. Unsystematic risk applies to any individual asset or narrow asset class, including shares, bonds tied to a specific issuer, or a small sector. It is not limited to property or fixed income.
Option d: 'Unsystematic risk is driven by macroeconomic events, which affect all assets equally.' This describes systematic (market) risk, not unsystematic risk. Macroeconomic events tend to impact a wide range of assets, making their effects broadly correlated; unsystematic risk arises from asset-specific factors like a company’s management or product issues and can be diversified away.
In summary, option a correctly identifies the diversification rationale behind the absence of compensation for unsystematic risk, while options b, c, and d mischaracterize the nature or scope of unsystematic risk and its role in pricing.

Ms Brown is reviewing her investment portfolio of Australian shares with her advisor. Which of the following statements best explains why investors are typically not compensated for taking on unsystematic risk?Single choice

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