David increases the number of companies in which he holds stocks.

Question

a. This reduces market risk.
b. This raises market risk, but lowers firm-specific risk. What happens to overall risk is unclear.
c. This raises firm-specific risk, but lowers market risk. What happens to overall risk is unclear.
d. This reduces firm-specific risk.

Answer 1

The correct answer is:

d. This reduces firm-specific risk.

When David increases the number of companies in which he holds stocks, he is diversifying his portfolio. This diversification helps to reduce firm-specific risk (also known as unsystematic risk), which is the risk associated with individual companies. However, it does not significantly affect market risk (systematic risk), which is related to the overall market movements. Therefore, by holding stocks in more companies, he reduces firm-specific risk while the overall market risk remains unchanged.