Which of the following types of investment risk cannot be eliminated through diversification?

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BlackTom AI · Accepted Answer

Let's lay out the scenario and the choices to understand what each one means in the context of diversification.
Option a: Unsystematic risk. This is the risk specific to a single company or industry, such as a management issue or a product failure. Diversification directly addresses this type because spreading investments across many securities reduces the impact of any one failing firm.
Option b: Accounting risk. This refers to uncertainties in financial reporting, such as misstatements or aggressive accounting. While diversification helps with portfolio-level risk, accounting risk is tied to individual firms and reporting practices; it can be mitigated through due diligence and strong auditing, but not inherently diminished by simply holding a broader mix of unrelated stocks to the same degree as unsystematic risk. It’s not a core market risk, but it also isn’t a purely diversification-type risk.
Option c: Systematic risk. This is the risk that affects the entire market or a broad segment of the market, such as economic recessions, inflation, or changes in interest rates. Diversification cannot eliminate this risk because all investments in the market tend to move together in response to macroeconomic forces; adding more stocks doesn’t remove the market-wide influence.
Option d: Business risk. This category covers the inherent risks of operating a particular business, including competitive position, pricing power, and cost structure. Like unsystematic risk, many business-specific factors can be mitigated by diversification, which reduces exposure to any single business’s fortunes.
In summary, the key distinction is that diversification can reduce risk tied to individual securities or industries (unsystematic and some business-specific factors) but cannot remove risk that impacts the entire market or economy (systematic risk). This explains why option c is the one that cannot be eliminated through diversification, while the others can be mitigated to varying extents through broad diversification and prudent analysis.

Which of the following types of investment risk cannot be eliminated through diversification?

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