Question

Which type of risk that is associated with investments can be diversified away under the right conditions?

Answer 1

Diversifiable risk or Unsystematic risk is simply risk that is specific to a particular security or sector so its impact on a diversified portfolio is limited. An example of a diversifiable risk is the risk that a particular company will lose market share. Also known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residualrisk," in the context of an investment portfolio, unsystematic risk can be reduced through diversification.

Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. Types of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, and/or a product recall.

Example : By owning a variety of company stocks across different industries, as well as by owning other types of securities in a variety of asset classes, such as Treasuries and municipal securities, investors will be less affected by single events. For example, an investor, who owned nothing but airline stocks, would face a high level of unsystematic risk. She would be vulnerable if airline industry employees decided to go on strike, for example. This event could sink airline stock prices, even temporarily. Simply the anticipation of this news could be disastrous for her portfolio.

By adding uncorrelated holdings to her portfolio, such as stocks outside of the transportation industry, this investor would spread out air-travel-specific concerns. Unsystematic risk in this case affects not only specific airlines but also several of the industries, such as large food companies, with which many airlines do business. In this regard, she could diversify away from public equities altogether by adding US Treasury Bonds as an additional protection from fluctuations in stock prices.

Even a portfolio of well-diversified assets cannot escape all risk, however. The portfolio will still be exposed to systematic risk, which refers to the uncertainty that faces the market as a whole and includes shifts in interest rates, presidential elections, financial crises, wars, and natural disasters.