Question

What are the main types of risk and to what extent can diversification reduce risks associated with stock portfolios?

Answer 1

There are usually two types of risk related to investments of the stocks in portfolio and they could be said to be systematic risk and unsystematic risk.

Unsystematic risk are also known as firm specific risk and industry specific risk which are specifically related to a particular firm or a particular industry and these risks are diversifiable so these risks can be diversified to a large extent and can even be eliminated so there can be unsystematic risk in the portfolio if better diversification policies to be followed.

when we are purchasing a stock there is a firm specific risk related to specific factors of the firm and when we are combining the portfolio with a large group of stocks which are not just limited to one sector but different sectors of the economy than we are adopting the principles of diversification in which unsystematic risk is eliminated by investing into various stocks.

Examples of unsystematic risk should be related to demand and supply of a particular industry or litigation against particular firm.

Systematic risk refers to market risk and these will be including all such risks for operating into the economy and this can never be eliminated and these will be related to all such studies which are attributed to the market sectors like inflation as well as interest rates and change in the political rules and regulations so these are applicable to all the entities which our existing in the economy.

systematic risk are not diversified and they can only be managed to some extent by allocation into different asset classes.

Diversification can completely eliminate the unsystematic risk but it can not impact the systematic risk to any extent, so diversification is only effective against and systematic and firm specific risk.