Question

Diversification eliminates idiosyncratic (unique or firm-specific) risk but does not eliminate systematic risk. Evaluate this statement. What happens to the benefits of diversification as portfolios get larger? Why do you think there are changes to the benefits of diversification as portfolios get larger?

Answer 1

Diversification

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Different Types of Risk

Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is just a risk investors must accept.

The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

Idiosyncratic Risk

Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in investing in a specific asset – such as a stock – the risk that doesn’t affect the entire market or an entire investment portfolio. It is the opposite of systemic risk, which affects all assets. Systemic risks include things such as changing interest rates or inflation.

Idiosyncratic risks are more rooted in individual companies (or individual investments). Investors can mitigate idiosyncratic risks by diversifying their investment portfolios.

Idiosyncratic Risk vs. Systemic Risk

With idiosyncratic risk, factors that affect assets such as stocks and the companies underlying them make an impact on a microeconomic level. It means that idiosyncratic risk shows little if any, correlation to overall market risk. The most effective way to mitigate or attempt to eliminate idiosyncratic risk is diversification.

Idiosyncratic risk, by its very nature, is unpredictable. Studies show that most of the variation in risk that individual stocks face over time is created by idiosyncratic risk. If an investor is looking to cut down on the risk’s potentially drastic impact on his investment portfolio, he can accomplish it through investment tactics such as diversification and hedging. The strategy involves investing in a variety of assets with low correlation, i.e., assets that don’t typically move together in the market. The theory behind diversification is that when one or more assets lose money, the rest of an investor’s non-correlated investments gain, thus hedging his losses.

Systemic risk, on the other hand, involves macroeconomic factors that affect not just one asset, but most assets, as well as the market and various economies in general. Adding more assets to a portfolio or diversifying the assets within it cannot counteract systemic risk.

Common Forms of Idiosyncratic Risk

Every company and its stock face their own inherent risks. Some of the most common types of idiosyncratic risk include the choices a company’s management makes in relation to operating strategies, financial policies, and investment strategy. Other forms of regularly recurring idiosyncratic risk include the general culture and strength of the company from within and where its operations are based.

Types of idiosyncratic risk:

• Operating strategies
• Financial policies
• Corporate culture
• Investment strategy

Non-idiosyncratic risks, in contrast, affect the entire market as a whole. They include taxation policies, inflation, interest rates, and economic growth or decline.

Why You Should Diversify

• Let's say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. That means your portfolio will experience a noticeable drop in value.
• If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.
• But, you could diversify even further because there are many risks that affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies. Statisticians, for example, would say that rail and air stocks have a strong correlation.
• Therefore, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.
• It's also important to diversify among different asset classes. Different assets such as bonds and stocks will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio's sensitivity to market swings. Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.
• And finally, don't forget location, location, location. Diversification also means you should look for investment opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.