Unsystematic risk:

Question

Unsystematic risk:

BlackTom AI · Accepted Answer

Unsystematic risk is firm- or asset-specific risk that can be diversified away, so the correct answer is: can be effectively eliminated through portfolio diversification.

1. Relevant knowledge points and concepts
- Total risk of an asset = systematic (market) risk + unsystematic (idiosyncratic) risk.
- Systematic risk affects all assets (economic cycles, interest rates) and cannot be eliminated by diversification.
- Unsystematic risk arises from firm-specific events (management, lawsuits, product failures) and is diversifiable.
- Beta measures systematic risk; investors are compensated (risk premium) only for systematic risk.

2. Step-by-step reasoning
- Consider a portfolio of n equally weighted, otherwise identical assets. Each asset’s return variance can be decomposed into market variance (σ_m^2) and idiosyncratic variance (σ_e^2).
- Portfolio variance = σ_m^2 + (1/n)σ_e^2 because market component is common to all assets while idiosyncratic components average out.
- As n increases, (1/n)σ_e^2 → 0, leaving only σ_m^2. Therefore unsystematic risk vanishes with sufficient diversification.

3. Intermediate calculation steps (illustrative)
- Single asset variance = σ_m^2 + σ_e^2.
- Equally weighted portfolio variance = Var(portfolio) = σ_m^2 + (1/n)σ_e^2.
- For n = 1: Var = σ_m^2 + σ_e^2. For n = 10: Var ≈ σ_m^2 + 0.1σ_e^2. As n → ∞: Var → σ_m^2.

4. Why the correct answer is correct
- The mathematical decomposition shows idiosyncratic risk contribution shrinks with more independent holdings, so unsystematic risk can be effectively eliminated via diversification.

5. Why other options are incorrect
- "Is related to the overall economy." — That describes systematic risk, not unsystematic.
- "Cannot be avoided if you wish to participate in the financial markets." — False: unsystematic risk can be avoided by holding a diversified portfolio.
- "Is measured by beta." — Beta measures systematic (market) risk, not unsystematic risk.
- "Is compensated for by the risk premium." — Risk premium compensates investors for bearing systematic risk, not diversifiable idiosyncratic risk.

6. Conclusion
This explanation confirms the provided answer: unsystematic risk can be effectively eliminated through portfolio diversification.

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