Question

‘Diversification enables us to reduce some of the risk in a portfolio but market risk will always remain.’ Do you agree with this statement? Discuss.

Answer 1

Yes, we do agree with this statement.

The risk for any security can mainly be classified into systematic and unsystematic risks.

Systematic risk are the risks which are associated with the market and the overall economy. Any change in the macro-economic condition affects all the security irrespective of the business model or financials of the security. For eg. consider an FMCG company with very strong financials and strong business models with high growth projections. Let's say a factor has taken place, such as a pandemic has started. Now, such events affect the overall market and there is nothing that is specific to the company. Such market risks are called as systematic risks.

Unsystematic risks are risks associated with security per se. It may be a case that a company's business model is flawed, or its financials are weak, and so on. Let's say a luxury car automobile company with high leverage. The risk associated with the company is limited to itself. Such risk is called unsystematic risk because it is stock-specific and doesn't relate to the overall market

Diversification helps reduce the unsystematic risks. A stock return might have a positive correlation with a certain event, where as another stock return can have negative correlation with that event. If both the stocks are included in the portfolio, the net effect of that particular event on the portfolio returns will be less. As more stocks are included, such unsystematic risk associated is reduced due to diversification. The market risk or the systematic risk, however, will affect all the stocks returns irrespectively of their individual charateristics. No matter how many stocks are included in the portfolio, the systematic or market risk will always remain because market factors affect all the securities.