The market portfolio is fully diversified and has only systematic risk

The market portfolio is fully diversified and has only systematic risk. The market portfolio is fully diversified and has only systematic risk. True False

The correct answer and explanation is:

Correct Answer: True

The statement is true. In modern portfolio theory and the Capital Asset Pricing Model (CAPM), the market portfolio is considered to be perfectly diversified. This means it holds every risky asset in the market, weighted by its market value. Because it includes every asset, it captures all possible sources of risk that cannot be eliminated through diversification. These remaining risks are known as systematic risks or market risks. Examples of systematic risk include changes in interest rates, inflation, recessions, or geopolitical events that affect the entire market and cannot be avoided by holding a diversified portfolio.

When investors diversify by holding more assets from different industries and sectors, they reduce unsystematic risk, which is specific to individual companies or industries. For example, the risk that a single company might face bankruptcy is an unsystematic risk, and it can be offset by holding other companies that are not affected by the same factors. As the number of assets in a portfolio increases, the impact of unsystematic risk becomes negligible. Therefore, in theory, the market portfolio eliminates all unsystematic risk because it includes everything.

Only systematic risk remains for the market portfolio, and this risk affects all investments simultaneously and cannot be diversified away. Investors are rewarded for bearing systematic risk because it cannot be avoided through diversification. This is why, under CAPM, an asset’s expected return depends on its sensitivity to systematic risk, measured by its beta relative to the market. An investor holding the market portfolio assumes the average amount of systematic risk and thus earns the market return. The idea that the market portfolio only has systematic risk is central to understanding how risk and expected return are linked in finance theory.