Your client feels "safe" because she owns eight mutual funds. All eight are large-cap U.S. equity with 70% overlap. She diversified her fund count, not her risk.
Every investment carries risk. The first task is classification.
Systematic risk (market risk, nondiversifiable) affects the entire market. Interest rate changes, inflation, recessions, and geopolitical events hit all securities simultaneously. No amount of diversification eliminates it.
Unsystematic risk (specific risk, diversifiable, idiosyncratic) is unique to a company, industry, or sector. Adding 20 to 30 uncorrelated positions across sectors and geographies eliminates virtually all of it.
HIGH-FREQUENCY: The exam presents a scenario and asks you to classify the risk. The classification itself determines the measurement tool (beta vs. standard deviation) and whether diversification helps.
When market rates rise, existing bonds with lower coupons become less attractive and their prices fall. The relationship is inverse. Sensitivity is measured by modified duration, the percentage price change for a 1% change in yield. A portfolio with modified duration of 6.0 years loses approximately 6% if rates rise by 100 basis points.
Common mistakes
- Classifying interest rate risk as unsystematic. It is systematic: it affects all fixed-income securities when rates change. Diversification does not help. Shortening duration does. Trap: "Add more bond funds to reduce interest rate risk", more bonds does not reduce a systematic risk.
- Believing diversification eliminates all risk. It eliminates unsystematic risk only. Systematic risk remains fully intact. A perfectly diversified portfolio still drops in a broad market crash. Trap: "Portfolio standard deviation = 0" is only possible at correlation of exactly -1.0.
- Confusing beta with total risk. Beta measures only systematic risk. A stock can have low beta but high total risk from idiosyncratic volatility. R-squared tells you how much of total risk is systematic.
Bottom line
- Systematic risk (market-wide, nondiversifiable): interest rate, inflation, currency, reinvestment, political; investors are compensated for bearing it
- Unsystematic risk (company-specific, diversifiable): business, financial, credit, liquidity, concentration; eliminated by holding 20-30 uncorrelated positions
- Beta measures systematic risk only and feeds CAPM; standard deviation measures total risk
- R-squared > 0.70 = use Treynor (beta); R-squared < 0.70 = use Sharpe (std dev)
Exam shortcut
Match the risk to the facts: retiree drawing income = sequence-of-returns. Client with 70% in one stock = concentration. U.S. investor in European equities with weakening euro = currency. Microcap holder needing cash tomorrow = liquidity. "Price and Income move opposite": rates up = prices down but reinvestment up. Duration matching neutralizes both. "70 is the gate": R-squared above 0.70 = Treynor; below 0.70 = Sharpe.
The full lesson (about 2,240 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- D.28
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