Question

Diversifiable and non-diversifiable risk are the core concepts in this chapter. From theft and earthquake insurance examples, we learned why we can readily reduce individual specific risk while common risks do not. To check your understanding, could you find an actual example relevant to two different types of risk, and how you can (or cannot) diversify those two? Please follow the steps:

1) Find actual examples on the Internet or other sources (Do not quote from Investopedia.com or marketinsight.com...they are not proper sources! No credit will be given if you cited them). It does not necessarily one source, you can combine multiple sources or examples to show different risks.

2) Summarize briefly how this example works (as we see in theft and earthquake examples), states assumptions, and which one is diversifiable and the other one is not.

Answer 1

Diversifying risk - It is also known as unsystematic risk, is defined as the danger of an event that would affect an industry and not the market. This type of risk can only be mitigated through diversifying investments and maintaining a portfolio diversification. This is like putting all of your eggs in one basket.

The concept is best understood by breaking down the requisite elements. The risk element is defined as a potential risk confined to that company or its market. If a company or a investor has a diversified portfolio, then the risk is mitigated because the company's other investments will not be affected. The term diversifiable risk is also synonymus with unsystematic risk. Things that would be considered unsystematic would be strikes, product malfunctions, boycotts etc.

This term is often used in business when assessing the security of one's portfolio. The investor who only owns investments in one company has a high non systematic risk. By investing in other company stocks and changing his portfolio mix, the investor can lower the impact of an adverse event in one industry having a devastating effect on their entire portfolio.

Example - Johnny owns stock in a car company. Recent reports have been released that show the car company Johnny has invested in actively practices discrimination. Because of these reports multiple boycotts that target this car company have been initiated. The long-standing effects of this boycott have damaged the car company's stock and Johnny is beginning to see a negative return on his investment.

Scenario 1 - Johnny does not have investments in any other companies, so Johnny's residual risk was extremely high in this instance.

Scenario 2 - Johnny has several investments in unrelated sectors, so his risk was relatively low because the boycott only affects part of his portfolio.

This event qualifies as an unsystematic risk because the general risk of a boycott occurring is not systematic. Boycotts are events that cannot typically be foreseen, are not inevitable and do not occur with any level of regularity.

Non diversifiable risk - It can be referred to a risk which is common to a whole class of assets or liabilities. The investment value might decline over a specific period of time only due to economic changes or other events which affect large sections of the market. However, diversification and asset allocation can provide protection against non diversifiable risk as different sections of the market have a tendency to underperform at different times. Non diversifiable risk can also be referred as market risk or systematic risk.

Putting it simple, risk of an investment asset ( real estate, bond, stock /share etc.) which cannot be mitigated or eliminated by adding that asset to a diversified investment portfolio can be delineated as non diversifiable risks. Moreover, this is the risk you are exposed to in an individual investment. This risk type is involved in almost every investment i.e uncertainty of market moving up or down and the particular movement of the investment.