Diversifiable Risk Definition
Diversifiable risk, also known as unsystematic risk, is defined as firm-specific risk and hence 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. So even if the industry is showing good growth, this particular firm will face challenges and shareholders of the same might see lower prices even though the industry might be doing good.
Components of Diversifiable Risk
Three major components of diversifiable risk are as follows:
#1 – Business Risk
Business risk arises because of the challenges a firm faces while doing business. They can be both internal and external but are only specific to the firm. Let’s say a pharma major firm spends a considerable amount of funds in the research and development but could not find the patent for it, then this will affect the cash flow and profitability of the firm. This will an internal example of diversifiable risk. On the other hand, if the firm is able to release the new product in the market but after 2 weeks it is banned as it failed some checks then this will be an external business risk.
#2 – Financial Risk
Financial Risk is purely an internal risk of the firm as it related to how the capital and cash flow is structured across the firm. For a firm to be solvent and pass through times of turmoil, it is necessary that the capital structure is robust and the firm has an optimal level of debt and equity.
#3 – Management Risk
This is the riskiest and most difficult to manage segment for the firm. Change in leadership has a huge impact as there is always a threat of close associates of the outgoing leader also resigning. This not only impacts the future strategic growth but also the current strategic transformations that the firm is undergoing. And least of all to say there can be said that no strategy in the world can counter for the corporate governance issue.
Examples of Diversifiable Risk
The simplest way to mitigate diversifiable risk is to diversify. Let’s try to understand it with a simple example. Consider a mutual fund who invests on behalf of their investors and is bullish on IT sectors. The fund wants to invest $ 120,000.
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There can be two scenarios:
# Scenario 1
Since the mutual fund is bullish on the IT sector, it invests in the firm with not only the most robust model but is also the market leader in its segment – Google (Alphabet). The firm is hopeful of double-digit growth and invests with a time frame of 5 years at a price of $ 1200. The stock gives a consistent return of 15% for the first 3 years as expected. However, in the 4th year, the European union put some regulations to curb privacy issues that have been long-standing. This affects Google’s business model and affects its profitability. This leads to stock crashing by 40%. However, Google resolves these issues soon and in the 5th the year the stock is back on track and gives a 20% return. Overall the total return across 5 years is 14% because of 1 very bad year.
Investment without Diversification
Amount post 5 Years of Google
- Amount post 5 Years of Google =136878.75
- Return = 14%
# Scenario 2
Instead of putting all money in Google, the firm invests across 4 major IT firms – Google, Facebook, Apple, Accenture keeping the initial investment equal to $ 120,000. Let us assume that facebook, apple, and Accenture give much lower returns compared to Google but they are not affected by any regulatory decision. Hence even though they don’t give high returns but also did not crash like Google in year 4.
Investment with Diversification
Amount post 5 Years of Google
- Amount post 5 Years of Facebook = 68439.38
- Return = 14%
Amount post 5 Years of Facebook
- Amount post 5 Years of Facebook = 32210.20
- Return = 61%
Similarly, we calculate the amount post 5 years and return of apple and Accenture.
Total return for scenario 2, considering cashflows of apple and Accenture similar to Facebook.
Therefore, the total amount of post 5 years will be as follows,
- Total Amount Post 5 Years =152939.72
Return will be –
= (152939.72 – 60000 – 60000)/(60000 + 60000)
Return = 27%
For detailed calculations, please refer to the attached excel sheet above.
The distinction in returns of the two scenarios clearly depicts how diversification protects your returns and initial investments.
Important Points to Note About Diversifiable Risk
- Diversifiable or unsystematic risk is a firm-specific risk compared to systematic risk which is an industry the specific risk or more specifically the risk impacting the whole market or sector. It is an unpredictable risk and can occur any time may be due to – a scam, labor strike, regulatory penalty, management reshuffle, internal factors or any such news specific to the firm.
- Diversifiable risk as to the term denotes means the risk that can be reduced without negatively impacting returns and the best part is that it can be mitigated by following simple diversification strategies in your investments. For example, to diversify risk in IT stocks one can diversify its investments in Google, Accenture, and Facebook.
The diversifiable risk though might sound like unnecessary, it is one of the necessary investments one should make if one wants to not only have better returns but also safeguard the initial principal. There can be no other way to make sure that you are not affected by firm-specific unsystematic risks.
This has been a guide to Diversifiable Risk and its definition. Here we discuss the components of diversifiable risk, its calculation with an example, and important points. You can learn more about asset management from the following articles –