1. is the risk associated with the variability of asset returns that remains after a diversified portfolio has been selected.
2. arises because asset returns are correlated with each other.
3. is positively related to asset returns.
4. is all of the above.
Choose the correct option?
The correct option is 4. Variations in the returns to assets that are unrelated to each other can be diversified away by holding a large number of such assets in a portfolio---if appropriate weights are attached to the individual assets and there are a large enough number of them, the variability of the portfolio return can be reduced virtually to zero. When the returns to the assets are positively correlated with each other, however, as is usually the case, diversification cannot remove all the variations in asset returns. The remaining variations represent nondiversifiable risk. The greater this remaining variability is in a particular portfolio, the less desirable will be the portfolio, the lower the prices of the assets in it will be (on average) relative to earnings, and the greater will be the portfolio return.
Non-diversifiable risk is a characteristic not only of portfolios, but of the individual assets themselves. To the extent that an asset's return fluctuates in greater amplitude than other assets as the average return to all assets rises and falls, it will contribute more variability to any diversified portfolio containing it. It will therefore be less desirable and sell for a lower price in relation to earnings than those assets that fluctuate less in response to market-wide variations in return. This is another way of saying that its return per dollar invested will be greater.