Diversifiable Risk Definition
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. So, even if the industry is showing good growth, this firm will face challenges, and shareholders might see lower prices even though the industry might be doing well.
Table of contents
- Diversifiable risk, also known as unsystematic risk, refers to firm-specific risks that affect individual stock prices rather than the entire industry or sector.
- The key components of diversifiable risk are business, financial, and management risks. Diversifiable risk is crucial for investors seeking better returns and protecting their initial investment.
- An uncertain risk can arise from various factors such as scams, labor strikes, regulatory penalties, management changes, internal issues, or news specific to the firm.
Components of Diversifiable Risk
The three major components of diversifiable risk are as follows:
#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. arises because of the challenges a firm faces while doing business. They can be internal and external but are only specific to the firm. For example, a major pharma firm spends a considerable amount of funds on research and development but cannot find a patent for it; 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.. That will include an internal example of diversifiable risk. On the other hand, if the firm can release the new product in the market, it is banned after two weeks as it failed some checks. That 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. is purely an internal risk related to how the firm’s capital and cash flow are structured. For a firm to be solvent and pass-through times of turmoil, the capital structure must be robust, and the firm must have an optimal level of debt and equity.
#3 – Management Risk
It 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. That impacts the future strategic growth and the current strategic transformations the firm is undergoing. And least of all to say, there can be said that no strategy in the world can counter corporate governance issues.
Examples of Diversifiable Risk
The simplest way to mitigate diversifiable risk is to diversify. Let us try to understand it with a simple example. Consider a mutual fund that invests on behalf of its investors and is bullish on IT sectors. The fund wants to invest $120,000.
There can be two scenarios:
# Scenario 1
Since the mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc 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 for $1,200. As expected, the stock gives a consistent return of 15% for the first three years. However, in the 4th year, the European Union enacted regulations to curb long-standing privacy issues. That affects Google’s business model and affects its profitability. It leads to stock crashing by 40%. However, Google resolved these issues soon. In the 5th year, the stock is back on track and gives a 20% return. Overall, the total returnTotal ReturnThe term “Total Return” refers to the sum of the difference between the opening and closing value of all the assets over a particular period of time and the returns thereon. To put it simply, the changes in opening and closing values of assets plus the number of returns earned thereof is the Total Return of the entity over a period of time. 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 its money in Google, it invests across four major IT firms – Google, Facebook, Apple, and Accenture. Keeping the initial investment equal to $120,000. Let us assume that Facebook, Apple, and Accenture give much lower returns than Google, but they are not affected by any regulatory decision. Hence, even though they do not provide high returns, they 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 the 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
The 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 riskUnsystematic RiskUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole. There are two types of unsystematic risk: business risk and financial 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 unnecessary. Nevertheless, it is one of the necessary investments if one wants to have better returns and safeguard the initial principal. There can be no other way to ensure that you are not affected by firm-specific unsystematic risks.
Frequently Asked Questions (FAQs)
Systematic risk, or non-diversifiable risk, is the risk that affects the overall market or a specific sector. It is influenced by factors that impact the entire economy, such as macroeconomic indicators, market sentiment, or geopolitical events. Diversifiable risk, or unsystematic risk, refers to firm-specific risks that can be reduced by diversifying a portfolio.
Diversifiable risk analysis is essential for investors and portfolio managers as it helps in understanding and managing the risks associated with individual securities or assets. By assessing and diversifying their investments, investors can reduce the impact of firm-specific risks and potentially improve their risk-return profile. Diversifiable risk analysis enables investors to make informed decisions about portfolio allocation, asset selection, and risk management strategies to achieve their investment objectives while mitigating unnecessary risks.
Diversifiable risk influences mutual funds by encouraging them to build diversified portfolios across various securities. By spreading investments across different companies, sectors, or asset classes, mutual funds aim to reduce the impact of individual firm-specific risks. This diversification helps enhance stability, lower volatility, and potentially improve risk-adjusted returns for mutual fund investors.
This article is 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: –