Question

In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

Answer 1

There are two types of risk : 1) Systematic Risk (or Non diversifiable) 2) Unsystematic Risk (or diversifiable). It is relevant for Investment. The following risks are Non diversifiable :

a) Market Risk: The Price of security may fluctuate due to changing psychology of the investor. The irrationality of security market may cause losses. These losses are the result of change in the general tenor of market are called market risk.

b) Interest Rate Risk : Change in interest rate is non diversifiable risk. As the interest rate goes up, the market price of existing fixed income security falls and vice versa.

c) Social or Regulatory Risk : Social or regulatory risk arises when there is adverse legislation, harsh regulatory climate by socialistic government.

d) Purchasing Power risk : Inflation or rise in prices leads to rise in cost of production, lower margin, wage rises and profit squeezing etc. The return expected by investor will change due to real value of return.

The following risks are diversifiable :

a) Business Risk : There are so many business risk which is diversifiable in nature. These may be extreme Competition, emergence of new technology, development of substitute product, shift in consumer preferences, inadequate supply of essential input etc.Principal factor may be of course inept and incompetent management.

b) Financial Risk : Financial risk refers to method of financing adopted by the company. High leverage ( i.e. debt financing) lead to larger debt servicing problem, short term liquidity problem.

An Investor can reduce the Unsystematic risk through diversification but can not in case of systematic risk. Unsystematic risk are unique to particular company or industry as opposed to market in case of systematic risk.