Diversifiable Risk

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:

Diversifiable-Risk.jpg

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For eg:
Source: Diversifiable Risk (wallstreetmojo.com)

#1 – Business Risk

Business riskBusiness RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.read more 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 firmProfitability Of The FirmProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more. This will include 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 riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more is purely an internal risk of the firm as it related to how the capital and cash flow are 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 impacts not only 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 that invests on behalf of their investors and is bullish on IT sectors. The fund wants to invest $ 120,000.

You can download this Diversifiable Risk Excel Template here – Diversifiable Risk Excel Template

There can be two scenarios:

# Scenario 1  

Since the mutual fundMutual FundA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more 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

Diversifiable Risk Example 1
  • =1368.79*100.00
  • Amount post 5 Years of Google =136878.75

Return

Diversifiable Risk Example 1.1png
  • =(136878.75-120000.00)/120000.00
  • 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

Example 2

=1368.79*50.00

  • Amount post 5 Years of Facebook = 68439.38

Return 

Example 2.1png
  • =(68439.38-60000.00)/60000.00
  • Return = 14%

Amount post 5 Years of Facebook

Example 2.2png

=322.10*100.00

  • Amount post 5 Years of Facebook = 32210.20

Return 

Example 2.3png
  • =(32210.20-20000.00)/20000.00
  • Return = 61%

Similarly, we calculate the amount post 5 years and the return of apple and Accenture.

Apple

Diversifiable Risk Example 2.4png

Accenture

Example 2.5png

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,

Example 2.6png
  • =68439.38+32210.2+26764.51+25525.63
  • Total Amount Post 5 Years =152939.72

The return will be –

Diversifiable Risk Example 2.7png

= (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

Conclusion

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.

Recommended Articles

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 –

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