Question

What are the main types of risk and to what extent can diversification reduce risks associated with stock portfolios?

Answer 1

There are mainly two types of risk associated with investment in stock portfolios and they are as follows-

1. Unsystematic risk or firm specific risk- unsystematic risk or firm specific risk are related specifically to the foyrm or the performance of the industry and they will be impacted by the demand and supply of the industry related factors and they are primarily related to the industry specific factor or firm specific and they will be diversifiable risk.

unsystematic risk or firm specific risk can be diversified because they are related to firm specific factors and when we will be including various different types of firms in the portfolio this risk will get eliminated and this risk can be completely eliminated by proper diversification.

Example of unsystematic risk will be demand and supply of a particular industry and litigation related to a particular company

2. Systematic risk or market risk- systematic risk is a risk which is related to market related factors and macro factors which will be impacting all the companies in the economy and this is there is risk which can never be diversified because it is the risk related to the operations in particular economy so market risk can only be lowered to some extent by investing into various asset classes but it can never be eliminated.

Market risk is also known as known as diversifiable risk because I can never be diversified as it is a risk related to operating in the industry so example of the market risk will be inflation along with interest rates.