Question

In broad terms, why is some risk diversifiable? Why is other risk non-diversifiable? Differentiate between the two types of risk. Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

Answer 1

To understand this question, we need to understand the types of Risk:

Total Risk = Systematic Risk + Unsystematic Risk.

Systematic Risk:

It is the risk due to macro-economic factors. It is the total market risk. It is diversifiable. It is a risk due to the Economy i.e. Markets Risk to Individual Companies.

Unsystematic Risk:

It is the risk due to microeconomic factors. It is an Individual Business risk. It is Undiversifiable. It contains Financial and Business Risk.

As Per Capital Market Theory (CMT) and Modern Portfolio Theory(MPT):

we need to Invest in as many stocks as we can to Kill the Systematic Risk.

CMT crux is that we need to Invest in Market Portfolio (all stocks of NYSE) to attain the highest Sharpe Ratio (i.e. the best Risk and Return Tradeoff)

Both this theory strongly suggest that Systematic Risk can be eliminated (and brought to minimum) via Diversification BUT Unsystematic Risk cannot be Eliminated.

So even if we Invest In all stocks of NYSE there will be Total Risk due to Unsystematic Risk not being eliminated.

But Investor can control the Unsystematic Risk by selecting the stock which has the least Unsystematic Risk.

But the same selection/control cannot be done for systematic Risk because it's the overall market risk.

(SELF NOTE: DO NOT FORM PART OF THE ANSWER

The above answer is given from Portfolio Managers Point of View who Invest in Market.

BUT

From An Individual Business Point of View:

Systematic Risk cannot be Eliminated as Macro Economic Factors are not in its Hands to control.

Unsystematic Risk can be Eliminated as Micro Economic Factors like Finance Risk, is in its Hands to control.)