Definition
Diversifiable risk, also known as unsystematic risk, refers to the risk associated with a particular investment that can be mitigated through investment in a well-diversified portfolio. This type of risk arises from factors that are specific to a particular company or industry, including management performance, competitive position, and labor force issues. Essentially, diversifiable risk can be reduced, or even eliminated, by holding a mix of investments that are not correlated to each other.
Key Takeaways
- Diversifiable Risk, also known as non-systematic risk, refers to the uncertainty linked to a specific company or sector, which may include events like a company’s strike, losing a very lucrative contract, or management issues.
- This risk can be reduced, or even eliminated, by sufficiently diversifying one’s investment portfolio. Unlike non-diversifiable risk, which affects the entire market, diversifiable risk impacts only a specific company or industry therefore a well-diversified portfolio can cushion the investor against this risk.
- Diversifiable risk is embedded in the specific enterprises or market sectors the investor selects, not the stock market as a whole. Hence, keen understanding of specific businesses, industries, and market sectors is essential in managing and mitigating diversifiable risks.
Importance
Diversifiable risk, also known as unsystematic risk, is an important concept in finance because it pertains to the risk that can be eliminated through diversification or by investing in a variety of assets.
This is crucial for investors because it allows them to reduce potential losses that might be associated with one specific asset.
If an investor puts all their money into one company or one sector and it does poorly, that investor stands to lose a lot.
But if they spread their investments across different companies or sectors, the gains from some could offset losses from others.
Therefore, understanding and effectively managing diversifiable risk is a key aspect of a successful investment strategy.
Explanation
Diversifiable risk, also known as unsystematic risk or unique risk, primarily serves the purpose of shedding light on the specific risk associated with investing in a single security or a portfolio consisting predominantly of similar security types. This could be a risk linked to a specific industry, market, region, or even a type of investment (like bonds, shares or real estate), which can fluctuate due to factors such as management inefficiencies, product failures, labor issues, or regulatory impacts.
Recognizing this risk can assist investors in implementing strategies to mitigate potential losses. The core utility of understanding diversifiable risk is embodied in the concept of portfolio diversification.
By spreading investments across a range of different asset classes, sectors, geographical regions, or securities, investors can buffer their portfolios against the unpredictable movements of a single asset. By doing so, the investor can manage and lower the effect of diversifiable risk.
Hence, the role of diversifiable risk is not just to indicate potential challenges within a portfolio, but also to guide strategic investment decisions to ultimately reduce that risk.
Examples of Diversifiable Risk
Investing in Tech Stocks: An investor who allocates too much of his portfolio to tech companies is exposed to diversifiable risk. If there’s a tech industry crash or shift in technology trends, the investor could suffer significant losses.
Real Estate Market: A real estate investor who only invests in properties within one geographical location or a specific type of property is exposed to diversifiable risk. If that area experiences a natural disaster or economic downturn, or if changes in the real estate market affect that specific type of property, the investor could suffer losses.
Automobile Manufacturing Investments: If an investor has most of his investments in one automobile company or in the automobile sector, he exposes himself to diversifiable risk. Suppose a scandal hits the sector or the specific company invested in, or there’s a sudden shift to different types of transportation, this investor stands to lose significantly.
FAQs on Diversifiable Risk
What is Diversifiable Risk?
Diversifiable risk, also known as unsystematic risk, is a risk that affects only a small number of assets and can be reduced through diversification. It is specific to a particular business or industry.
How is Diversifiable Risk different from Non-Diversifiable Risk?
While diversifiable risk is specific to a specific industry or company, non-diversifiable risk affects the entire market and cannot be avoided. Diversifiable risk can be mitigated through the inclusion of a variety of investments in your portfolio.
What are some examples of Diversifiable Risk?
Examples of diversifiable risk can include changes in management, employee strikes, product recalls, and other events that can affect a specific company or industry. The impact of these risks can be reduced by not putting all your eggs in one basket, so to speak, but by spreading investments across different companies and sectors.
How can I manage Diversifiable Risk?
Diversifiable risk can be managed through diversification. This involves spreading investments across different companies, industries, or types of securities. The idea is that if one investment performs poorly, it won’t drastically affect your entire portfolio because the other investments should perform differently.
Is Diversifiable Risk more or less important to consider than Non-Diversifiable Risk?
Both diversifiable and non-diversifiable risks are crucial to consider while investing. However, the focus may depend on the individual risk tolerance and investment strategy. Diversifiable risk can be controlled by the investor to a certain extent through prudent portfolio construction and management, while non-diversifiable risk requires more strategic planning due to its impact on the broader market.
Related Entrepreneurship Terms
- Portfolio Diversification
- Unsystematic Risk
- Asset Allocation
- Risk Management
- Non-Market Risk
Sources for More Information
- Investopedia: A comprehensive resource for investing and finance education. This platform offers definitions, articles, and tutorials on a wide range of financial concepts, including diversifiable risk.
- CFA Institute: A global, nonprofit member organization of financial analysts, portfolio managers, and other investment professionals. It offers deep insights into finance-related topics.
- Corporate Finance Institute (CFI): A provider of online financial analyst certification programs and continuing education courses for finance professionals. This includes topics like diversifiable risk.
- Yahoo Finance: An online platform which apart from providing latest financial news, also gives ample resources for understanding complex financial terms like diversifiable risk.
