Diversifiable Risk: Definition, Formula, Example, and FAQs
What Is Diversifiable Risk?
Diversifiable risk, also known as unsystematic risk or specific risk, refers to the portion of an investment's total risk that can be mitigated or eliminated through portfolio diversification. Within the realm of portfolio theory, it is the risk inherent to a specific company, industry, or asset, rather than the broader market. This type of risk stems from unique factors affecting a single security, such as a company's management decisions, product recalls, labor strikes, or a shift in consumer preferences for a particular good or service. Diversifiable risk stands in contrast to market risk, which cannot be diversified away. Effective risk management strategies emphasize minimizing diversifiable risk to enhance portfolio stability.
History and Origin
The concept of diversifiable risk is a cornerstone of Modern Portfolio Theory (MPT), a groundbreaking framework introduced by economist Harry Markowitz. In his seminal 1952 paper, "Portfolio Selection," Markowitz proposed that investors should not evaluate individual assets in isolation but rather consider how each asset contributes to the overall risk and return of a portfolio11, 12. His work mathematically demonstrated that combining assets whose returns are not perfectly positively correlated can reduce the total risk of a portfolio without necessarily sacrificing expected investment returns. This revolutionary insight formalized the long-held investment adage, "Don't put all your eggs in one basket," providing a scientific basis for the benefits of diversification. The Federal Reserve Bank of San Francisco highlights that Markowitz's theory provided a mathematically precise way to analyze the risks and rewards of adding diversified assets to portfolios, making it a foundation for how capital is allocated by both retail investors and institutions10.
Key Takeaways
- Diversifiable risk is the component of an investment's total risk that can be reduced or eliminated through proper portfolio diversification.
- It arises from company-specific or industry-specific factors, such as management changes, product failures, or regulatory actions impacting a single sector.
- Diversifying a portfolio across various assets, industries, and geographies helps mitigate diversifiable risk.
- While diversifiable risk can be minimized, a portfolio will always retain systematic risk, which is inherent to the overall market.
- Modern Portfolio Theory emphasizes the importance of understanding and managing diversifiable risk to optimize portfolio efficiency.
Formula and Calculation
Diversifiable risk is not directly calculated by a standalone formula but is understood as the portion of a portfolio's total risk that disappears as diversification increases. The total risk of a portfolio can be decomposed into systematic risk and unsystematic (diversifiable) risk.
Total Risk = Systematic Risk + Unsystematic (Diversifiable) Risk
The effectiveness of diversification in reducing unsystematic risk depends on the correlation between the assets in the portfolio. When assets are added to a portfolio, especially those with low or negative correlations, the overall portfolio's standard deviation (a common measure of total risk) decreases. This reduction in the overall portfolio's volatility, attributable to the specific, non-market-wide factors, represents the diversifiable risk that has been eliminated. The ideal scenario involves combining assets whose idiosyncratic movements offset each other.
Interpreting Diversifiable Risk
Understanding diversifiable risk is crucial for investors as it directly informs their asset allocation decisions. A high level of diversifiable risk in a portfolio indicates that an investor is overly concentrated in a few specific assets or sectors, leaving them vulnerable to unique negative events affecting those holdings. Conversely, a portfolio that has successfully reduced its diversifiable risk suggests that the investor has spread their investments sufficiently, so that specific company or industry issues are unlikely to significantly impact overall investment returns.
For a well-diversified portfolio, the primary remaining risk is systematic risk, which reflects broad market movements. Therefore, the interpretation of diversifiable risk guides investors to ensure their portfolio structure minimizes the risks they can control, allowing them to focus on managing the risks they cannot.
Hypothetical Example
Consider an investor, Alex, who initially puts all of their capital into shares of a single equity company, "Tech Innovators Inc." Tech Innovators Inc. is a burgeoning startup specializing in a new, unproven technology. Alex's portfolio, consisting solely of this one stock, carries a significant amount of diversifiable risk. If Tech Innovators Inc. announces a major product recall due to a critical flaw, or if its CEO resigns unexpectedly, the stock price could plummet, severely impacting Alex's entire investment. This event is specific to Tech Innovators Inc. and not necessarily indicative of the broader financial markets.
Now, imagine Alex decides to diversify. They sell half of their Tech Innovators Inc. shares and invest the proceeds into a mix of established technology companies, a stable utility company, a real estate investment trust (REIT), and government bonds. In this diversified portfolio, if Tech Innovators Inc. still faces a product recall, the impact on Alex's overall portfolio would be significantly dampened. While the Tech Innovators Inc. shares might still drop, the other investments, largely unaffected by the recall, would help cushion the loss, demonstrating how diversifiable risk is mitigated through spreading investments across various unrelated assets.
Practical Applications
Diversifiable risk is a fundamental concept applied across various aspects of investing and financial planning:
- Portfolio Construction: Investors actively seek to minimize diversifiable risk by building portfolios with a variety of assets that have low correlations. This includes diversifying across different asset classes (stocks, bonds, real estate), industries, geographic regions, and company sizes.
- Mutual Funds and ETFs: One of the primary benefits offered by mutual funds and exchange-traded funds (ETFs) is inherent diversification. These pooled investment vehicles hold a basket of securities, automatically spreading out diversifiable risk for investors who might not have the capital or expertise to build a highly diversified portfolio on their own. The U.S. Securities and Exchange Commission (SEC) emphasizes that diversification is key to lessening investment risks and is a core feature of mutual funds, which invest in a range of companies and industries to lower risk if one company fails8, 9.
- Regulatory Frameworks: Regulatory bodies often impose diversification requirements on certain investment vehicles, such as mutual funds, to protect investors. For instance, the Investment Company Act of 1940 specifies criteria for funds to be classified as "diversified," often involving limits on the percentage of assets that can be invested in any single issuer6, 7.
- Risk Assessment: Financial analysts and portfolio managers explicitly consider diversifiable risk when assessing the overall risk profile of a client's portfolio. They often use statistical tools to measure the unique risk contribution of each asset and to determine the extent to which a portfolio is exposed to unsystematic factors.
- Case Studies in Failure: Major corporate scandals or collapses, such as the Wirecard fraud, serve as stark reminders of the impact of unmitigated diversifiable risk. The Wirecard scandal, which involved allegations of widespread accounting fraud and resulted in the company's insolvency, demonstrates how a single company's failings can lead to massive losses for concentrated investors. Such events underscore the importance of diversification in protecting against unique, company-specific downturns3, 4, 5.
Limitations and Criticisms
While the concept of diversifiable risk is central to effective portfolio management, it is not without limitations. The primary critique is that diversification cannot eliminate all risk. A portfolio, no matter how broadly diversified, will always be exposed to systematic risk. This market-wide risk, driven by macroeconomic factors like interest rate changes, inflation, recessions, or geopolitical events, affects all investments to some degree and cannot be diversified away.
Furthermore, some academic theories, like the Efficient Market Hypothesis (EMH), suggest that in a truly efficient market, all available information is immediately reflected in asset prices, making it impossible to consistently earn abnormal returns by exploiting mispricings or reducing specific risks through active management2. While practical evidence often shows market inefficiencies and opportunities for skilled diversification, proponents of EMH might argue that the effort to mitigate diversifiable risk beyond a certain point yields diminishing returns, as the market quickly adjusts to new information1.
Another limitation arises from practical implementation. Achieving perfect diversification can be challenging due to transaction costs, illiquid markets, or the sheer number of assets required. Additionally, behavioral biases can lead investors to over-concentrate, underestimating their exposure to diversifiable risk in favored assets or sectors. The pursuit of outsized gains can sometimes lead investors to take on excessive idiosyncratic risk in highly speculative or niche investments. beta, a measure of systematic risk, becomes the more relevant metric for assessing risk once diversifiable risk has been largely eliminated.
Diversifiable Risk vs. Systematic Risk
Diversifiable risk and systematic risk are two fundamental components of total investment risk, often confused but distinct in their nature and manageability.
| Feature | Diversifiable Risk (Unsystematic/Specific Risk) | Systematic Risk (Market/Non-Diversifiable Risk) |
|---|---|---|
| Origin | Specific to a company, industry, or asset (e.g., product recall, labor strike, management error). | Inherent to the entire market or economy (e.g., inflation, interest rate changes, recessions, pandemics). |
| Manageability | Can be reduced or eliminated through portfolio diversification. | Cannot be eliminated through diversification; affects all assets to some degree. |
| Reward | Investors are typically not rewarded for taking on this risk, as it can be diversified away. | Investors are generally rewarded for bearing this risk with higher expected returns (e.g., via the Capital Asset Pricing Model (CAPM)). |
| Impact | Affects a limited number of assets or a particular sector. | Impacts the broad market and most assets within it. |
The key distinction lies in an investor's ability to control them. Diversifiable risk is within an investor's control through prudent asset selection and allocation, whereas systematic risk is a macro-level factor that investors must accept if they wish to participate in the market.
FAQs
Can diversifiable risk ever be completely eliminated?
No, while diversifiable risk can be significantly reduced through broad portfolio diversification, it is almost impossible to eliminate it entirely. Real-world constraints such as transaction costs, the availability of uncorrelated assets, and the practical limits to how many different investments an individual can manage mean that some residual diversifiable risk may always exist.
How many stocks does it take to diversify away diversifiable risk?
The exact number varies, but studies and empirical observations generally suggest that adding between 20 to 30 well-chosen, non-highly correlated stocks from different industries and sectors can significantly reduce the majority of diversifiable risk. Beyond this point, the benefits of further diversification in terms of risk reduction tend to diminish, with the remaining risk being predominantly systematic risk.
Is diversifiable risk the same as unique risk?
Yes, diversifiable risk is often used interchangeably with "unique risk" or "idiosyncratic risk." All these terms refer to the specific, non-market-related risks associated with an individual asset or a small group of assets that can be mitigated through diversification.
Why is managing diversifiable risk important for investors?
Managing diversifiable risk is crucial because it allows investors to optimize their risk-adjusted returns. By reducing the risks specific to individual holdings, investors can achieve a more stable and predictable portfolio performance. This focus on risk management aligns with the principles of Modern Portfolio Theory (MPT), which seeks to maximize return for a given level of risk.