Stocks have both diversifiable risk and undiversifiable risk, but only diversifiable risk is rewarded with higher expected returns.

Question

Quizplus · Accepted Answer

Both diversifiable risk and undiversifiable risk are factors that contribute to total risk, but only undiversifiable risk is rewarded with higher expected returns. Diversifiable risk can be eliminated by proper diversification, so rational investors will not demand higher returns for bearing this type of risk. In contrast, undiversifiable risk, also known as market risk, affects the entire market and cannot be diversified away. Therefore, investors expect to be compensated with higher returns for bearing this type of risk.

Stocks Have Both Diversifiable Risk and Undiversifiable Risk, but Only