Diversifiable risk

From CEOpedia | Management online

Diversifiable, or unsystematic, risk is a type of investment risk that can be reduced by diversifying investments across different asset classes. This type of risk is specific to an individual security or asset, and can be controlled by an investor through their portfolio construction. Examples of diversifiable risk include the risk of a company’s stock price declining due to a decrease in demand, or the risk of a company becoming insolvent due to mismanagement. Diversification reduces the overall risk of a portfolio by offsetting the risk of one security with the gains of another, meaning that the impact of diversifiable risk can be minimized through a well-constructed portfolio.

Example of Diversifiable risk

For example, if an investor owns stock in a single company, and that company experiences a decrease in demand, then the investor will experience a loss in their portfolio. However, if the investor diversifies their portfolio by investing in different asset classes, such as bonds, mutual funds, and real estate, then the impact of the decrease in demand for the single stock can be minimized. By diversifying their investments across different asset classes, the investor can reduce the overall risk of their portfolio.

  • Company-specific risk: The risk of a company’s stock price declining due to a decrease in demand or the risk of the company becoming insolvent due to mismanagement.
  • Industry-specific risk: The risk of a company’s stock price declining due to a decrease in demand or the risk of the company becoming insolvent due to mismanagement within a particular industry.
  • Currency risk: The risk of a company’s stock price declining due to a decline in the value of a particular currency.
  • Interest Rate Risk: The risk of a company’s stock price declining due to a rise in interest rates.

When to use Diversifiable risk

Diversifiable risk is most effective when an investor is looking to reduce the risk of their portfolio without sacrificing potential returns. By diversifying across different asset classes, an investor can reduce their exposure to any individual security or asset. This allows them to maintain their desired level of risk while still allowing for potential gains. Additionally, diversifying across different asset classes can provide a more balanced portfolio, allowing investors to achieve their desired return goals with less volatility.

In summary, diversifiable risk is a type of risk that can be reduced by diversifying investments across different asset classes. Diversifying investments across different asset classes reduces the overall risk of a portfolio by offsetting the risk of one security with the gains of another, and allows investors to maintain their desired level of risk while still allowing for potential gains. Additionally, diversification can provide a more balanced portfolio and allow investors to achieve their desired return goals with less volatility.

Types of Diversifiable risk

  • Market Risk: This type of risk is associated with the general movements of the market. Market risk is caused by changes in economic and political factors, such as changes in interest rates, inflation, and exchange rates.
  • Credit Risk: Credit risk is the risk of a borrower defaulting on their loan due to an inability to make payments. This type of risk is associated with the creditworthiness of a borrower, and can be minimized by investing in high-quality borrowers.
  • Liquidity Risk: Liquidity risk is the risk that an investor will be unable to liquidate an investment due to a lack of buyers. This type of risk is associated with the liquidity of an asset, and can be minimized by investing in highly liquid assets.

Steps of Diversifiable risk

  • Allocation of Assets: A key step in reducing diversifiable risk is to properly allocate assets within a portfolio. Diversifying investments across different asset classes, such as stocks, bonds, real estate, and mutual funds, can help to reduce unsystematic risk.
  • Managing Risk: Managing diversifiable risk also involves evaluating and monitoring investments. Regularly reviewing investments and adjusting asset allocations as needed can help minimize the impact of unsystematic risk on a portfolio.
  • Diversification: Diversifying investments across different asset classes can help reduce the overall risk of a portfolio. Investing in a variety of asset classes can help to offset the risk of any one security, and will help to reduce the impact of unsystematic risk.

Advantages of Diversifiable risk

  • Diversifiable risk can be effectively managed through portfolio construction. By diversifying investments across different asset classes, investors can reduce the overall risk of their portfolio, as the negative impact of one security can be offset by the positive gains of another.
  • Diversifying investments across different asset classes also allows investors to take advantage of a wider range of opportunities. For example, a portfolio that includes stocks, bonds, and real estate can offer greater potential for returns than a portfolio that only includes stocks.

Disadvantages of Diversifiable risk

  • Diversifying investments across different asset classes can be a costly process, as investors will need to pay fees for the investment vehicles they are using, as well as for any professional advice they may be seeking.
  • Diversifiable risk can also be difficult to measure, as it is specific to each individual security or asset. This means that investors may not be able to accurately predict the impact of diversifiable risk on their portfolio.

Limitations of Diversifiable risk

Despite the benefits of diversifiable risk, there are some limitations to consider. Firstly, diversifiable risk can be expensive to manage, as it often requires a large amount of capital to diversify across different asset classes. Additionally, diversifying a portfolio can often require specialized knowledge and expertise, which can be difficult for novice investors. Finally, the risk of unsystematic risk may be difficult to predict, as it is specific to individual securities and assets.

Other approaches related to Diversifiable risk

There are several other approaches related to diversifiable risk, such as:

  • Asset Allocation: Asset allocation is the process of allocating funds to different asset classes, such as stocks, bonds, and cash. By creating an optimal asset allocation strategy, investors can reduce their overall risk by investing in a variety of asset classes.
  • Risk Tolerance: Risk tolerance is a measure of how much risk an investor is willing to take on. By understanding their risk tolerance, investors can create a portfolio that is tailored to their individual needs and risk preferences.
  • Trend Following: Trend following is a strategy used to identify and exploit trends in the markets. By following trends, investors can capitalize on short-term market gains and reduce the impact of diversifiable risk.

In summary, diversifiable risk is a type of risk that can be minimized through portfolio construction and other related approaches such as asset allocation, risk tolerance, and trend following. By utilizing these strategies, investors can reduce their exposure to risk and maximize their returns.


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References

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