diversifiable risk

Examples of diversifiable risk in the following topics:

• The Capital Asset Pricing Model

  • The current risk-free rate is 5%.
  • It determines what the rate of return of an asset will be, assuming it is to be added to an already well-diversified portfolio, given that asset's systematic risk.
  • Systematic risk - also called market risk or non-diversifiable risk - represents the risk present in a security in relation to the economy as a whole.
  • Unsystematic risk - also called idiosyncratic risk or diversifiable risk - represents the risk present in a security that is specific to that investment and unrelated to the overall risk of the market .
  • CAPM states that in market equilibrium, investors are only rewarded for bearing systematic risk - the type of risk that cannot be diversified away.

• Defining the Security Market Line

  • The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.
  • The security market line graphs the systematic, non-diversifiable risk (stated in terms of beta) versus the return of the whole market at a particular time, and shows all risky marketable securities.
  • The Y-intercept of the SML is equal to the risk-free interest rate.
  • Recall that the risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
  • The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.

• Impact of Diversification on Risk and Return: Unsystematic Risk

  • In general, diversification can reduce risk without negatively impacting expected return.
  • In finance, systematic risk is the term associated with risk that can be diversified away by investing in a broader pool of assets.
  • Diversification comes with a cost associated with it, and some might point out that it is possible to over-diversify.
  • The idea is that you can only diversify away so much risk, that the marginal returns on each new asset are decreasing, and each transaction has a cost in terms of a transaction fee and also research costs.
  • The risk that can be diversified away is called "unsystematic risk" or "diversifiable risk. "

• The Relationship Between Risk and Return and the Security Market Line

  • Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk.
  • In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic risk.
  • Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if the asset's price sensitivity is greater than the market; equal to one when the asset's sensitivity is equal to the market; and less than one if the asset exhibits less pricing volatility than the market.
  • The market risk premium is determined from the slope of the SML.
  • If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk.

• Portfolio Risk

  • In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets.
  • If there is zero correlation among all three fruits, we have cut our risk in thirds by owning all three, but if they are perfectly correlated, we haven't diversified away any of our risk.
  • If our portfolio of investments has diversified away as much risk as is possible given the costs of diversifying, our portfolio will be attractive to investors.
  • If our bowl does not diversify away enough risk, it will not lie on the Security Market Line for those who we are trying to recruit into buying our portfolio.
  • Thus the only portfolios that are efficient investments are those that effectively diversify the underlying risk away and price their investment efficiently .

• Impact of Diversification on Risk and Return: Systematic Risk

  • By diversifying a portfolio of assets, an investor loses the chance to experience a return associated with having invested solely in a single asset with the highest return.
  • As a result, the portion of risk that is unsystematic -- or risk that can be diversified away -- does not require additional compensation in terms of expected return.
  • This type of risk cannot be diversified away, and is referred to as systematic risk.
  • This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.
  • Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.

• Portfolio Diversification and Weighting

  • In finance, there are two types of risk – systemic risk and specific risk.
  • It can be diversified away.
  • The risk associated with the one mountain is called "specific risk. " The risk of bad weather, in this example, is systemic risk.
  • The idea of eliminating risk by spreading investments across pools of underlying stocks and bonds is called "diversification. " A diversified portfolio spreads investments across all asset classes with a weighting system that takes time frame and risk tolerance into account.
  • In our example. we talked about diversifying away the risks of slow chair lifts but in reality, there are many more aspects to diversification.

• Overview of How to Assess Stand-Alone Risk

  • Total Beta is a measure used to determine risk of a stand-alone asset, as opposed to one that is a part of a well-diversified portfolio.
  • Total Beta is a measure used to determine the risk of a stand-alone asset, as opposed to one that is a part of a well-diversified portfolio.
  • It is also known as unitized risk or the variation coefficient.
  • A lower coefficient of variation indicates a higher expected return with less risk.
  • For this reason, it becomes useful to us in finance to measure the risk of an investment in a way that it is not dependent upon other types of risk, such as that of the overall market.

• The Value of Diversification

  • The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset.
  • In general, most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class .
  • It's important to note that diversification does not remove all of the risk from the portfolio.
  • Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk).
  • Systematic risk will affect the portfolio, regardless of how diversified it is.

• Implications for Variance

  • A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a single asset portfolio.
  • As you can see from the graphic below, there is still considerable risk to an investor who is heavily invested in stocks, even with a blended portfolio.
  • Here are some examples of the the types of assets that may be included in a diversified strategy:
  • This is why it's possible to reduce variance without compromising expected return by diversifying.
  • Diversifying asset classes can reduce portfolio variance without diminishing expected return