Question

how are risk and return related?

why is some risk diversifiable and some risk non diversifiable?

how do you eliminate as much risk as possible from your investment portfolio?

Answer 1

There is a positive correlation between risk and return. It is often said that people who are willing to take more risks are awarded with more returns. If a stock provides a higher return then risk associated with such stock will also be greater. Higher Return from a stock will always attract investor but they should also be vary of the risk.

There are two types of Risk

Systematic Risk or Non Diversifiable Risk - It is the volatility of a stock on account of economy wide factors. It affects all stocks in the same direction with unequal sensitivity. It is the risk which is inherent to the market and it cannot be avoided through diversification.

Unsystematic Risk or Diversifiable Risk - It is the volatility of a stock on account of internal company specific factors. This risk can be avoided through diversification. The greater the number of stocks in the portfolio the greater is the chance of Unsystematic Risk getting cancelled out.

How to eliminate Unsystematic Risk or Diversifiable Risk

The investor needs to hold a diversified portfolio. As he keeps on increasing the number of stocks in his portfolio Diversifiable Risk gets reduced. Adding stocks with lower coefficient of correlation will also result in maximum benefit of diversification.