Question

Why are some risks diversifiable and some nondiversifiable? Give an example of each.

Answer 1

For better understanding first of all let’s know something about diversifiable and nondiversifiable risks.

Diversifiable risk is such risk which can be eliminated with the help of widening the investment portfolio. If we make investment in various types of securities and in various assets then risks can be eliminated or diversified.

Nondiversifiable risk is such type of risk which affect overall portfolio hence it means with the help of widening the portfolio such risks can not be eliminated or diversified.

Now come to main point that is; why some risks are diversifiable and some risks are non-diversifiable in nature?

Answer is very simple. As we have already discussed that some risks affect overall portfoilo and all types of assets that is why these risks can not be eliminated or diversified and these risks are known as non-diversifiable risks.

For example; risk due to inflation, risk due to war, risk due to international incident etc. So it is clear that these risks will affect overall securities and assets that is why these risks can not be eliminated or diversified with the help of diversification of portfolio.

Now let’s see second aspect, some risks are diversifiable in nature because these risks afffect particular security or particular asset hence an investor can manage risk with the help of widening the portfolio or with the help of investment in various types of securities. For example; risk due to strike in a particular company, risk due to lawsuit, risk due to marketing policy of a particular company etc. Hence it is clear that these risk will affect a particular company or will affect some particular security hence investor can diversify its risk with the help of widening its portfolio or with the help of investment in various companies’ securities.