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Diversifiable risk

What Is Diversifiable Risk?

Diversifiable risk, also known as unsystematic risk or specific risk, refers to the portion of an investment portfolio's total risk that can be reduced or eliminated through diversification. It is a key concept within portfolio theory, which emphasizes how combining different assets can optimize the risk-return trade-off for investors. Unlike market risk, which affects all investments in the market, diversifiable risk is unique to a specific company, industry, or asset class. This type of risk arises from factors such as a company's management decisions, product recalls, labor strikes, or changes in consumer preferences. Effective asset allocation strategies are designed to minimize diversifiable risk by spreading investments across a variety of securities that are not perfectly correlated.

History and Origin

The concept of diversifiable risk is deeply rooted in Modern Portfolio Theory (MPT), a groundbreaking framework introduced by economist Harry Markowitz. Markowitz published his seminal paper, "Portfolio Selection," in The Journal of Finance in 1952.8 His work revolutionized investment management by demonstrating that investors should not consider individual securities in isolation but rather how they interact within a portfolio.7 Before MPT, the focus was primarily on selecting individual assets with the highest expected return. Markowitz introduced the idea that by combining assets whose returns are not perfectly correlated, the overall portfolio risk could be reduced without necessarily sacrificing expected returns. This mathematical approach formally laid the groundwork for understanding and managing diversifiable risk.6

Key Takeaways

  • Diversifiable risk is specific to an individual company, industry, or asset, stemming from unique internal or industry-specific events.
  • It can be reduced or eliminated through the strategy of diversification by combining various assets in a portfolio.
  • Factors contributing to diversifiable risk include management changes, new product failures, operational disruptions, or regulatory actions affecting a single entity.
  • Modern Portfolio Theory provides a framework for understanding how diversification helps mitigate this type of risk.
  • Investors utilize diversified holdings, such as mutual funds and exchange-traded funds, to manage diversifiable risk effectively.

Formula and Calculation

Diversifiable risk, often represented as the unsystematic component of total risk, is typically not calculated as a standalone formula but rather as a residual once systematic risk is accounted for. Total risk (variance of portfolio returns) can be decomposed into systematic and unsystematic (diversifiable) components.

The total variance of a portfolio ((\sigma_p^2)) can be expressed as:

σp2=βp2σm2+σϵ2\sigma_p^2 = \beta_p^2 \sigma_m^2 + \sigma_{\epsilon}^2

Where:

  • (\sigma_p^2) = Total variance of the portfolio's returns.
  • (\beta_p2 \sigma_m2) = Systematic risk component.
    • (\beta_p) = Portfolio's beta, a measure of its sensitivity to market movements.
    • (\sigma_m^2) = Variance of the market's returns.
  • (\sigma_{\epsilon}^2) = Diversifiable risk (unsystematic variance), representing the portion of risk unique to the specific assets in the portfolio.

As more uncorrelated assets are added to a portfolio, the (\sigma_{\epsilon}^2) term, which represents diversifiable risk, tends to decrease, moving the portfolio closer to the efficient frontier where only systematic risk remains.

Interpreting Diversifiable Risk

Interpreting diversifiable risk involves understanding that this type of risk is within an investor's control through prudent portfolio construction. If a portfolio exhibits a high level of diversifiable risk, it indicates a concentrated exposure to specific company or industry factors. For example, owning shares in only one company means the investor is fully exposed to all the risks unique to that company. By adding more securities across different industries and sectors, an investor can dilute the impact of any single company-specific event. A well-diversified portfolio aims to minimize, if not eliminate, diversifiable risk, allowing investors to primarily focus on managing market risk, which cannot be diversified away. Effective risk management strategies depend on this understanding.

Hypothetical Example

Consider an investor, Alice, who initially puts all her savings into shares of "Tech Innovators Inc.," a single technology company. Her portfolio has a very high level of diversifiable risk. If Tech Innovators Inc. faces a major lawsuit due to a product malfunction, or its new software release bombs, Alice's entire investment could be severely impacted. The specific events affecting Tech Innovators Inc. represent diversifiable risk.

To mitigate this, Alice decides to diversify. She sells a portion of her Tech Innovators Inc. shares and invests in a broad index fund that holds stocks from hundreds of companies across various sectors, including manufacturing, healthcare, and consumer goods. She also considers investing in different asset classes, such as bonds. Now, if Tech Innovators Inc. experiences a downturn, the impact on Alice's overall portfolio is lessened because the negative performance of one company is offset by the stable or positive performance of other, uncorrelated assets in her diversified portfolio. This strategic allocation significantly reduces her exposure to diversifiable risk.

Practical Applications

Diversifiable risk is a fundamental consideration in various real-world financial contexts. In portfolio construction, investors and financial managers actively seek to reduce it by creating portfolios with low correlation among assets. This means combining investments that do not typically move in the same direction in response to specific events. For instance, holding stocks from different industries—like a technology company and a utility company—helps to offset the unique risks of each sector, such as specific industry risk or adverse regulatory changes.

Regulators also emphasize diversification to protect investors. The U.S. Securities and Exchange Commission (SEC), for example, has specific rules for investment companies, particularly mutual funds, to qualify as "diversified." Under the Investment Company Act of 1940, a diversified investment company generally must have at least 75% of its total assets represented by cash, government securities, securities of other investment companies, and other securities where no more than 5% of its total assets are invested in any one issuer, and it owns no more than 10% of an issuer's voting securities., Th5i4s "75-5-10 rule" encourages broad diversification and limits exposure to the diversifiable risk of any single entity. These regulations help ensure that publicly offered investment products adhere to principles that reduce investor exposure to company-specific downturns. The diversification requirements are critical for funds operating within the capital markets.

Limitations and Criticisms

While the concept of diversifiable risk is central to portfolio management, it has limitations, particularly when viewed through the lens of Modern Portfolio Theory (MPT). Critics argue that MPT, and by extension the management of diversifiable risk, often relies on assumptions that may not hold true in real-world scenarios. For example, MPT assumes that asset returns are normally distributed and that correlations between assets remain static, which is often not the case, especially during periods of market stress. Ext3reme events can lead to correlated declines across seemingly uncorrelated asset classes, diminishing the effectiveness of diversification in reducing diversifiable risk.

Furthermore, effectively eliminating diversifiable risk requires a significant number of assets, which can lead to diminishing returns from diversification benefits after a certain point. The practical costs of extensive diversification, such as increased transaction fees or the complexity of managing a very large portfolio, can sometimes outweigh the marginal reduction in diversifiable risk. Behavioral finance also critiques the assumption of rational investor behavior inherent in MPT, suggesting that psychological factors can influence investment decisions and, consequently, risk perception and management. The2 Enron scandal, for instance, exemplified how significant operational risk and financial risk specific to one company can lead to its downfall, demonstrating that even sophisticated investors can be exposed to severe diversifiable risks if due diligence fails.

Diversifiable Risk vs. Systematic Risk

The primary distinction between diversifiable risk and systematic risk lies in their origin and the ability to mitigate them. Diversifiable risk, as its name suggests, is specific to a particular asset or a small group of assets and can be reduced through diversification. It arises from unique factors affecting a company or industry, such as a product recall, a change in management, or a specific regulatory investigation. For example, if a car manufacturer announces a major recall, its stock price might fall significantly, representing a diversifiable risk to its shareholders.

In1 contrast, systematic risk, also known as non-diversifiable risk or market risk, affects the entire market or a broad segment of it and cannot be eliminated through diversification. This type of risk stems from macroeconomic factors like inflation, interest rate changes, geopolitical events, or widespread economic recessions. Every investment carries some level of systematic risk because no asset is completely insulated from overall market movements. For instance, a rise in interest rates impacts the borrowing costs for nearly all companies and can depress stock prices across the board, making it a systematic risk. Investors accept systematic risk as an inherent part of participating in the broader financial markets, while they actively manage diversifiable risk.

FAQs

Can diversifiable risk be completely eliminated?

While diversification can significantly reduce diversifiable risk, completely eliminating it in a real-world portfolio is challenging. As more assets are added, the marginal benefit of further diversification diminishes. However, a well-constructed and sufficiently diversified portfolio can reduce exposure to company-specific and industry risk to negligible levels.

How does diversification reduce diversifiable risk?

Diversification reduces diversifiable risk by combining assets whose returns do not move in perfect lockstep. When one asset performs poorly due to a specific event, other assets in the portfolio may perform well or remain stable, thereby offsetting the losses. This balancing act smooths out the overall portfolio's return volatility that stems from unique, asset-specific events.

What are some common examples of diversifiable risk?

Common examples of diversifiable risk include a company's product failing in the market, a negative legal judgment against a specific firm, an unexpected labor strike impacting a single business, a key executive resigning, or a natural disaster affecting a particular production facility. These are all events unique to a specific company or sector that can be mitigated by holding a variety of different investments.

Is diversifiable risk more important to manage than systematic risk?

Both diversifiable risk and systematic risk are important, but they require different management approaches. Investors have direct control over diversifiable risk through their portfolio construction choices, making its management a critical component of individual portfolio management. Systematic risk, being market-wide, cannot be diversified away and thus typically requires strategies like hedging or adjusting overall market exposure. For long-term investors, managing systematic risk often involves considering their overall risk tolerance and investment horizon within the broader capital markets.