Question

Choose the correct statements within Portfolio risk concept:

1)    Total portfolio risk (σ) is equal to nonsystematic risk plus non-diversifiable risk.

2)    Total portfolio risk (σ) is equal to systematic risk minus nonsystematic risk.

3)    Adding assets to a portfolio can reduce its systematic risk.

4)    Each new asset added to a portfolio will reduce its diversifiable risk, but after a certain amount of assets in portfolio this effect will be close to 0.

5)    Market risk can be reduced to 0 by adding assets to a portfolio.

		1, 3, 5
		3, 4
		2, 3, 5
		1, 4

Answer 1

Correct statements are 1 and 4.

Statement 1 is correct. Total portfolio risk is equal to nonsystematic risk plus non-diversifiable risk. non-diversifiable risk is also known as systematic risk which is the market risk and affect all firms in the economy. nonsystematic risk is the risk which affect only some particular firms and avoided by including stocks of firms of different industries.

Statement 4 is correct. Each new asset added to a portfolio will reduce its diversifiable risk, but after a certain amount of assets in portfolio this effect will be close to 0. this is because a large no. of assets will starting moving in the same direction due to positive correlation and they will lose their risk diversifying effect.

Statement 2 is incorrect because Total portfolio risk includes both systematic risk and nonsystematic risk.

Statement 3 is incorrect because systematic risk can not be avoided by adding assets to the portfolio. systematic risk affects the entire economy. so no firm can avoid its effect.

Statement 5 is incorrect because Market risk is the systematic risk which can't be avoided by adding assets to the portfolio. Market risk affects the entire economy. examples of market risks are interest rate change and inflation rate change.