In portfolio theory, how is unsystematic risk fundamentally distinguished from systematic risk, and how can it be mitigated by a mutual fund manager?

[ A ]Unsystematic risk affects the entire national economy, while systematic risk affects only a single small-cap stock.

[ B ]Both risks can be 100% eliminated by investing exclusively in 30-year corporate debentures.

[ C ]Unsystematic risk is company/industry-specific and can be reduced through diversification across unrelated securities, whereas systematic risk affects the entire market and cannot be diversified away.[ CORRECT ]

[ D ]Systematic risk is reduced by diversifying across stocks, while unsystematic risk requires closing the stock exchange.

Takeaway

Option C is correct: Unsystematic risk is company/industry-specific and can be reduced through diversification across unrelated securities, whereas systematic risk affects the entire market and cannot be diversified away.

Derivation

Unsystematic (company-specific or diversifiable) risk arises from events impacting a specific firm or industry (e.g., management changes, strikes, product recalls). Holding a broad portfolio of uncorrelated securities diversifies away unsystematic risk. In contrast, systematic (market or non-diversifiable) risk stems from macroeconomic forces (interest rates, inflation, geopolitical crises) affecting all securities simultaneously and cannot be eliminated through diversification. Finance theory states investors are only compensated for non-diversifiable systematic risk. This tests foundational risk theory. The common error is inverting the definitions.

Why the others fail

A — Unsystematic risk affects the entire national economy, while systematic risk affects only a single small-cap stock.

This option completely reverses the definitions; systematic risk impacts the macro economy, while unsystematic risk is company-specific.

B — Both risks can be 100% eliminated by investing exclusively in 30-year corporate debentures.

Long-term corporate debentures carry high credit and interest rate risk and do not eliminate financial market risks.

D — Systematic risk is reduced by diversifying across stocks, while unsystematic risk requires closing the stock exchange.

Systematic market risk cannot be diversified away, whereas unsystematic risk is systematically reduced via portfolio diversification.