How can unsystematic risk be mitigated in an investment portfolio?

How can unsystematic risk be mitigated in an investment portfolio?

• A. By increasing capital reserves
• B. Through diversification
• C. By focusing on a single asset
• D. By avoiding risk altogether

Answer: (B)

Unsystematic risk, often referred to as specific or idiosyncratic risk, is the risk associated with a particular company or industry. This type of risk can be mitigated through diversification, which involves spreading investments across various assets or sectors. When a portfolio includes a mix of different investments, the negative performance of one asset can be offset by the positive performance of others, thereby reducing the overall risk. Diversification allows investors to diminish the impact of any single underperforming investment, leading to a more stable and less volatile portfolio. In contrast, increasing capital reserves would improve the financial cushion of the business but wouldn't directly reduce the risks associated with specific investments. Focusing on a single asset would actually increase exposure to unsystematic risk, as any adverse events affecting that asset could lead to substantial losses. Finally, avoiding risk altogether isn't a practical strategy in investment, as it typically results in missed opportunities for growth and returns. Therefore, diversification stands out as the most effective method for mitigating unsystematic risk.

Unsystematic risk, often referred to as specific or idiosyncratic risk, is the risk associated with a particular company or industry. This type of risk can be mitigated through diversification, which involves spreading investments across various assets or sectors. When a portfolio includes a mix of different investments, the negative performance of one asset can be offset by the positive performance of others, thereby reducing the overall risk. Diversification allows investors to diminish the impact of any single underperforming investment, leading to a more stable and less volatile portfolio.

In contrast, increasing capital reserves would improve the financial cushion of the business but wouldn't directly reduce the risks associated with specific investments. Focusing on a single asset would actually increase exposure to unsystematic risk, as any adverse events affecting that asset could lead to substantial losses. Finally, avoiding risk altogether isn't a practical strategy in investment, as it typically results in missed opportunities for growth and returns. Therefore, diversification stands out as the most effective method for mitigating unsystematic risk.