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Table of Contents
- Introduction
- Total risk
- No-diversified risk
- Diversified risk
- Diversified risk as only relevant risk
- Conclusion
Introduction
The relationship between total risk, no-diversifiable risk, and diversifiable risk are in the context of the level of diversifiable in the investment portfolio, which is critical in identifying the type of risk to diversify as economic investment environment dynamically changes. In this case, diversifiable risk is the only relevant risk because of its specificity
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Total risk
An aggregate of all the total factors associated with making an investment decision is referred to as total risk. Each of the factors associated with making decisions that have the potential to adversely impacts on business investment making are classified into no-diversifiable and diversifiable risks, making total risks.
In this case, total risk needs to be assessed before making an investment to avoid the potential for making loses, which are outcomes that significantly vary from the expected value and financial returns. In this case, the link between total risks and other risks is separated from each other by the Capital Asset Pricing Model (CAPM), in theory.
Here, total risk in finance can be market dependent with attributes where the different market drivers determine the degree of returns for a risk to impact investments. While total risk underlies the perspective of risk in its varied forms, one of the forms of risk is no-diversifiable risk.
No-diversified risk
No-diversifiable risk, which is also referred to as systematic risk is defined in the context of the entire class of assets and liabilities. The rationale for this type of risk is that the value of an asset depreciates with time as economic factors change with changing market conditions. That is because the risk of an investment asset cannot be mitigated, and that affects both corporate and individual investments.
The latter makes it mandatory to add the asset into a diversified investment portfolio, which is then delineated into the no-diversifiable risk. In context, market risks, purchasing power risks, and interest rate risks underlie the driver factors no-diversifiable risk. Another element of risk is diversifiable risk.
Diversified risk
On the other hand, diversifiable risk is risk defined in the context of unsystematic risk which can be removed through diversification since it belongs to part of an asset’s risk. In this case, diversifiable risk can be narrowed into specific asset-related events in a firm that can be in the form of regulatory actions, lawsuits, loss of a key account, and strikes.
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The underlying cause of diversifiable risk is industrial specific events such as pricing, marketing, research and development, and labor unions. Here, diversifiable risk is in the context of business risks, default risks, and financial risks. The key characteristic of diversifiable risk is that it has limited impact on diversified portfolio. Comparatively, diversifiable risk is the only relevant risk.
Diversified risk as only relevant risk
That diversifiable risk is the only relevant risk is correct. That is because diversifiable risk is limited to a specific asset and can be accurately identified in relation to its impact on an asset. That is in addition to the fact that such a risk allows for diversification depending on the universe of investment and can be controlled by hedging.
Conclusion
There are strong relationship and differences between the total risk, no-identifiable risk, and indefinable risk, with each defines in the context of risk, but varying in the diversification or no-diversification portfolio.
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FAQs
No, we are still subject to general economic risk that affects all securities. This leftover risk is referred to as Non-diversifiable risk (or market/systematic risk). Examples of non-diversifiable risks include political events (such as wars), energy price shocks, changes in interest rates, recessions, etc.
How are total risk, non-diversifiable risk, and diversifiable risk related to each other? ›
Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk. Once diversified, investors are still subject to market-wide systematic risk. Total risk is unsystematic risk plus systematic risk.
What is an example of a diversified risk? ›
Diversifiable risk is also known as unsystematic risk. It is defined as firm-specific risk and impacts the price of that individual stock rather than affecting the whole industry or sector in which the firm operates. A simple diversifiable risk example would be a labor strike or a regulatory penalty on a firm.
Which one of the following is the best example of a diversifiable risk? ›
Answer. The best example of a diversifiable risk is a firm's sales decrease, as it's a risk specific to a particular company that can be mitigated by owning a diversified portfolio.
What is the difference between Diversifiable and non-Diversifiable risk? ›
Macroeconomic hazards are those that affect an investor's portfolio as a whole, regardless of the investments or asset classes they hold. Diversifiable risks can be mitigated by investing in a diversified portfolio, while non-diversifiable risks cannot be hedged against by spreading money over a variety of investments.
What is an example of Diversifiable risk that a financial manager should ignore? ›
Question: An example of diversifiable risk that a financial manager should ignore when analyzing a project's risk would include: commodity price changes labor costs overall stock price fluctuations risks of government.
Why is some risk Diversifiable Why are some risks non-Diversifiable? ›
Answer and Explanation:
These risks are related to specific security or specific asset so it can be reduced by making investment in other securities or asset. Risk that are systematic and that cannot be hedged or decreased is termed as non-diversifiable risk.
Is inflation a non-diversifiable risk? ›
Examples of non-diversified risks include systemic or market risks such as inflation.
How can diversifiable risk be eliminated? ›
The unsystematic risk is a unique risk or diversifiable risk or firm-specific risk which can be eliminated by creating a diversified portfolio. This risk is faced by a given firm and is not related to the market or industry conditions.
What is the best example of diversification? ›
With diversification, a business can successfully cross-sell their products. For example, an automobile company famous for its car deals can also introduce engine oil or other car parts to an old market or cross-sell new products.
Related Diversification —Diversifying into business lines in the same industry; Volkswagen acquiring Audi is an example. Unrelated Diversification —Diversifying into new industries, such as Amazon entering the grocery store business with its purchase of Whole Foods.
What is an example of diversification in risk management? ›
For example, a portfolio only investing in technology startups could suffer significant losses in a technology downturn. By diversifying across multiple sectors, an investor can mitigate the impact of sector-specific downturns.
Which of the following is an example of non-Diversifiable systemic risk for a firm? ›
Expert-Verified Answer
The correct answer to the question is e) Liability risk. Liability risk is an example of non-diversifiable (systemic) risk for a firm.
Is unemployment a non-diversifiable risk? ›
Inflation, unemployment and natural disasters, such as hurricanes, are examples of diversifiable risk.
What is a measure of diversifiable risk? ›
The standard deviation is a measure of diversifiable risk. Market risk can not be eliminated through portfolio diversification. Company-specific risk can not be eliminated through portfolio diversification.
What are examples of undiversifiable risk? ›
It is also known as market risk or undiversifiable risk and can arise from factors such as inflation, recessions, wars, changes in interest rates, fluctuations in currency exchange rates, natural disasters, and other macroeconomic events that impact the market as a whole.
What is an example of a non market risk? ›
This is distinct from systematic risk, the dangers inherent to the market as a whole. The most common examples of unsystematic risk are the risks that are specific to an individual firm. Examples can include management risks, litigation risks, location risks, and succession risks.
Is fire a non-diversifiable risk? ›
An example of a nondiversifiable risk is a fire.
Is market risk non-Diversifiable risk? ›
Market risk, also called systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways and tends to influence the entire market at the same time. Specific risk, in contrast, is unique to a specific company or industry.
