Why does the total risk of a portfolio not approach zero as the number of assets in a portfolio becomes very large?
This question touches on investment risk, which can be deconstructed into unsystematic risk and systematic risk. Unsystematic risk, also called idiosyncratic risk, reflects the risk associated with a specific asset, while systematic risk reflects the risk associated with an entire market
Answer and Explanation:
Unsystematic risk can be diversified away by construction a portfolio of assets with less than perfect correlations. Exposure to an array of positions mitigates the idiosyncratic risk inherent in each, as the ups and downs experienced by the individual positions largely washout in aggregate. Systematic risk, on the other hand, cannot be diversified away. This market-wide risk includes the impact of inflationary changes, interest rate changes, and movements in equities, commodities, and foreign currency prices.
Therefore, while adding many different assets to a portfolio will eliminate unsystematic risk, systematic risk (and some level of total risk) will always remain.
Become a member and unlock all Study Answers
Try it risk-free for 30 daysTry it risk-free
Ask a question
Our experts can answer your tough homework and study questions.Ask a question Ask a question
Learn more about this topic:
from Finance 305: Risk ManagementChapter 3 / Lesson 3