What characterizes unsystematic risk?

What characterizes unsystematic risk?

• A. It affects the entire market
• B. It can be diversified away
• C. It is synonymous with market risk
• D. It is predictable and manageable

Answer: (B)

The correct answer highlights that unsystematic risk can be diversified away. Unsystematic risk, often referred to as specific or idiosyncratic risk, pertains to factors that are unique to a particular company or industry, such as management decisions, product recalls, or competitive dynamics. Unlike systematic risk, which affects the entire market and cannot be avoided through diversification, unsystematic risk is specific to particular assets and can therefore be mitigated by investing in a diverse portfolio of securities. When investors diversify their investments across various sectors and companies, they reduce their exposure to the factors that could negatively impact any single investment, thereby minimizing the overall impact of unsystematic risk on their portfolio. This characteristic is a foundational principle of modern portfolio theory, where diversification is used as a key strategy to manage risk. In contrast, the other options mischaracterize unsystematic risk. The notion that it affects the entire market is a definition of systematic risk, not unsystematic risk. Saying it is synonymous with market risk also confuses systematic risk with unsystematic risk. Lastly, while some aspects of unsystematic risk can be managed to an extent, characterizing it as entirely predictable and manageable overlooks the inherent uncertainties and unique challenges that different companies

The correct answer highlights that unsystematic risk can be diversified away. Unsystematic risk, often referred to as specific or idiosyncratic risk, pertains to factors that are unique to a particular company or industry, such as management decisions, product recalls, or competitive dynamics. Unlike systematic risk, which affects the entire market and cannot be avoided through diversification, unsystematic risk is specific to particular assets and can therefore be mitigated by investing in a diverse portfolio of securities.

When investors diversify their investments across various sectors and companies, they reduce their exposure to the factors that could negatively impact any single investment, thereby minimizing the overall impact of unsystematic risk on their portfolio. This characteristic is a foundational principle of modern portfolio theory, where diversification is used as a key strategy to manage risk.

In contrast, the other options mischaracterize unsystematic risk. The notion that it affects the entire market is a definition of systematic risk, not unsystematic risk. Saying it is synonymous with market risk also confuses systematic risk with unsystematic risk. Lastly, while some aspects of unsystematic risk can be managed to an extent, characterizing it as entirely predictable and manageable overlooks the inherent uncertainties and unique challenges that different companies