Question

Diversification works because:I. unsystematic risk exists.II. combining stocks into a portfolio reduces the standard deviation of each stock in the portfolio.III. firm-specific risk can be dramatically reduced if not eliminated.A) I onlyB) III onlyC) I and II onlyD) I and III onlyE) I, II, and III

Answer 1

Answer:

D) I and III only.

Explanation:

II is false because the standard deviation of each stock is an inner characteristic of the stock and cannot be affected by combining it with other stocks in an investment portfolio. I. is true because each stock risk answer to the sector risk and company risk essentially, and by having stock of different sectors and companies is expected that unsystematic risks as these are off-setted. By having a portfolio with wide not-correlated stocks is expected that the risk can be reduced dramatically.