The Importance of Proper Diversification in Risk Management

C

The correct answer to the question is C. Unsystematic risk.

Unsystematic risk refers to the risk that is specific to an individual asset or a particular company within a portfolio. It is also known as company-specific risk or idiosyncratic risk. This type of risk is associated with factors that are unique to a specific investment, such as management decisions, competitive positioning, operational issues, or legal and regulatory concerns.

Proper diversification is a risk management strategy that involves spreading investments across different asset classes, sectors, industries, and geographic regions. The goal of diversification is to reduce unsystematic risk by not putting all your eggs in one basket. By holding a diversified portfolio, the impact of negative events or poor performance of individual assets or companies is minimized because losses in one investment can be offset by gains in others.

Portfolio risk, also known as investment risk, is a broader concept that encompasses both systematic risk and unsystematic risk. It represents the overall risk associated with a portfolio of investments. Systematic risk, on the other hand, refers to the risk that is inherent in the entire market or a particular market segment and cannot be eliminated through diversification. It includes factors such as interest rate fluctuations, inflation, economic recessions, political events, and market volatility. Systematic risk affects all investments to some extent and is beyond the control of individual investors.

Total risk is another term used to describe the overall risk of an investment or portfolio. It includes both systematic and unsystematic risk components. While diversification can reduce unsystematic risk, it cannot eliminate systematic risk, which is influenced by macroeconomic and market-wide factors.

In summary, unsystematic risk is avoidable through proper diversification. By constructing a well-diversified portfolio that includes investments from different asset classes and industries, investors can mitigate the impact of company-specific risks and improve the overall risk-return profile of their investments.