Difference between Diversifiable and Non-diversifiable Risk

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The classification of a security risk into "diversifiable" and "non-diversifiable" risks has come up from the portfolio approach of capital investment. It has culminated in the well-known and popular Capital Asset Pricing Model (CAPM), developed by Sharpe, Lintner, and others. According to this framework, the "diversifiable risk" is the risk that can be eliminated by diversification, while "non-diversifiable risks" are the risks that cannot be diversified away. Many investors define the two types of risks as two complementary components of the standard deviation (SD) of a security's rate of return.

Diversifiable Risk

Diversifiable risk is also called as "unsystematic risk". These risks are the risk of price change because of unique features of the particular security. Systematic risks are independent of the overall market conditions. Diversifiable risk can be partially or entirely eliminated by diversification of the portfolio.

Non-diversifiable Risk

Non-diversifiable risks are applicable to the entire class of assets or liabilities. The value of an investment in non-diversifiable risks declines over the period due to any other change that affects the major portion of the market, such as changes in the economic conditions of the country.

Non-diversifiable risk is also known as "systemic risk" or "market risk", as the risks are concerned with the market conditions. The notable factor to consider is that the total risk, non-diversifiable risk, and diversifiable risk are related to each other because the non-diversifiable and diversifiable risks are part of "total risk".

Note − Systematic risk is beyond the control of the investors, as it does not depend on decision-making or strategic conceptualization. Unsystematic or diversifiable risks are relevant to decision-making. Therefore, it is wrong to say that only non-diversifiable risks are relevant to the decision-making process of investors.

Factors responsible for the non-diversifiable risk

Non-diversifiable risk is a result of factors influencing the entire market, such as foreign investment policy, investment policy, altering of socio-economic parameters, alterations in taxation clauses, global security threats and measures, etc. The non-diversifiable risk is not under the investors’ control and is also quite tough to mitigate in general.

However, non-diversifiable risks can be identified by the analysis and estimation of the statistical relationships between the unique asset portfolios through different techniques, such as "principal components analysis." That is why there is no specific method to handle the non-diversifiable risk.

Published on 04-Oct-2021 09:33:16