Diversification and Systematic Risk

We've seen that unsystematic risk can be eliminated by diversifying. What about systematic risk? Can it also be eliminated by diversification? The answer is no because, by

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line

© The McGraw-Hill Companies, 2002

PART FIVE Risk and Return definition, a systematic risk affects almost all assets to some degree. As a result, no matter how many assets we put into a portfolio, the systematic risk doesn't go away. Thus, for obvious reasons, the terms systematic risk and nondiversifiable risk are used interchangeably.

Because we have introduced so many different terms, it is useful to summarize our discussion before moving on. What we have seen is that the total risk of an investment, as measured by the standard deviation of its return, can be written as:

Total risk = Systematic risk + Unsystematic risk

Systematic risk is also called nondiversifiable risk or market risk. Unsystematic risk is also called diversifiable risk, unique risk, or asset-specific risk. For a well-diversified portfolio, the unsystematic risk is negligible. For such a portfolio, essentially all of the risk is systematic.

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