ACCA Financial Management (F9) Certification Practice Exam

What risk can be reduced through diversification within a portfolio?

1. Systematic risk

2. Unsystematic risk

3. Market risk

4. Credit risk

The correct answer is: Unsystematic risk

Diversification within a portfolio is a strategy that aims to reduce unsystematic risk, also known as specific risk or residual risk, which is associated with individual assets. Unsystematic risk arises from factors that are specific to a single company or industry, such as management decisions, product recall, or regulatory changes. By including a variety of assets across different industries and sectors in a portfolio, the specific risks of individual investments tend to offset one another. For example, if one stock underperforms due to poor management decisions, other stocks in the portfolio may perform well and help to stabilize the overall returns, thus reducing the impact of the unsystematic risk. This is why the primary benefit of diversification is to mitigate the risks that are unique to individual securities rather than the broader market as a whole. In contrast, systematic risk, which affects the entire market, cannot be eliminated through diversification since it arises from broader economic factors such as interest rates, inflation, or geopolitical events. Market risk and credit risk also fall under the category of systematic risk, as they pertain to overarching market movements and the likelihood of a borrower defaulting, respectively. These risks require different management strategies, often involving hedging techniques or asset allocation to different types of asset classes rather