Essay Sample: Diversifiable and Non-diversifiable Risks in Investments

Why is some risk diversifiable?

Some risks are diversifiable because the associated asset's risks have random causes that can be eliminated by diversifying. Diversification of risk can help in reducing the risks. The diversifiable risks are specific to industries or markets. For example, company's financial performance, or the circumstances in specific industries affect specific stocks. These risks can be diversified to limit the impact of such risks. An investor can diversify the risk by investing in the stock of different companies in different sectors.

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Why are some risks non-diversifiable?

The non-diversifiable risks are not unique to a specific sector, or specific companies. For example, Interest rates fluctuation, economic recession, volatility and wars did not affect specific sectors but the whole economy. Lhabitant & Learned (2002) argued that Non-diversifiable risks mean that the impact of such risk is felt by all stock irrespective of the sector, industry or company. Once the stock market is affected by the global financial crisis, all stocks are affected

Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

Systematic risk is uncontrollable and inevitable to investors. A systemic risk affects the whole stock market making it difficult to control. The investors can only avoid systematic rips if they do not invest in the stock market but they cannot diversify the risk because all the stocks are affected. Diversifying investment to control systematic risk only results in more looses as all the stocks are affected. The severity of the risk associated with systematic risk is higher than investing in individual stocks. For example, during the 1997 Asian financial crisis, all stocks listed on the Hong Kong stock exchange were affected such that no investor had control.

The Asian financial crisis involved foreign exchange risk and interest risk. Unlike Hong Kong, countries like Indonesia, Thailand, and South Korea were negatively impacted by foreign exchanges. Nevertheless, for Hong Kong, interest rate risk damaged the financial industry greatly. On August 5, 1998, the interest rate jumped from 8% to 23%. It took everybody by surprise. Consequently, many people in Hong Kong could not afford their home mortgage and ended up bankruptcy in some cases. Besides the real estate industry, the stock market devastates as well. To prevent the stock market from crashing, the Hong Kong government bought back US$15 billion stocks in the market (Hill, 2018). Thus, in this scale, an investor cannot do anything to reduce risk. However, unsystematic risk only affects one sector, and an investor could reduce risk by proper diversification with investment strategy.

The investor can have significant control over a portfolio with unsystematic risk by diversification. Simply put this, do not put your eggs in one basket meaning that investors should use a broader pool of assets in order to manage risk and reduce the volatility. Investors might choose different asset classes, stocks in the medium between risk and return, etc. In addition, the investor can use Beta to monitor the volatility of stocks. One can predict the return of the asset by using the beta value. If the Beta value is higher than one, then the stock is riskier than the one whose beta is less than 1. Measuring risk can help the investors manage risk through either diversification or divesting from the risky asset.

References

Hill, C. (2018). The Asian Financial Crisis. Retrieved from http://www.wright.edu/~tdung/asiancrisis-hill.htm

Lhabitant, F., & Learned, M. (2002). Hedge Fund Diversification: How Much is Enough?. SSRN Electronic Journal, 21(11). doi: 10.2139/ssrn.322400