Question

Discuss the difference between diversifiable risk and market risk, and explain how each type of risk affects well-diversified investors.

Answer 1

Sl. No.	Parameter	Market Risk	Diversifiable Risk
1	Nature	Risks inherent inside a system; common to all the entities inside the system; prevalent in every instrument traded in the market	Risks specific to an entity, company or instrument; independent to external changes in economy or politics
2	Another way to look at it	These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole.	Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks.
2	Mitigation	Undiversifiable and cannot be controlled or eliminated merely by diversifying one's portfolio.	Controllable; can be considerably reduced by sufficiently diversifying one's portfolio through hedging or right asset allocation strategy
3	Also known as	Market risk, systematic risk, volatility	Unsystematic risk
4	Examples	Interest rate changes, inflation, recessions, wars.	Business risks, financial risks

A well diversified investor nearly eliminates all of the diversifiable risk and hence is not impacted by diversifiable risk. Hower, the market risk can npt be diversified away and hence even a well diversified investor is impacted adversely by market risk.