What is Diversifiable Risk?

Diversifiable risk is the possibility that there will be a change in the price of a security because of the specific characteristics of that security. Diversification of an investor’s portfolio can be used to offset and therefore eliminate this type of risk. Diversifiable risk differs from the risk inherent in the marketplace as a whole.

Characteristics of Diversifiable Risk

The following are the key characteristics of diversifiable risk:

Specific to an asset or entity. Diversifiable risk arises from factors that are unique to a particular company, industry, or region. Examples include management decisions, product recalls, labor strikes, and competitive dynamics.
Can be reduced through diversification. The impact of diversifiable risk can be minimized by holding a well-diversified portfolio of assets. Diversification spreads investments across various sectors, industries, or geographical regions, reducing exposure to any single risk.
Non-systemic in nature. Diversifiable risk does not affect the entire market or economy; it is localized to specific entities or circumstances.
Not correlated with the market. Diversifiable risk is uncorrelated with overall market movements, as it arises from specific, isolated factors. Thus, it affects the individual asset or a small group of assets rather than the entire market.
Limited scope. The scope of diversifiable risk is confined to specific circumstances, making it less pervasive than systematic risk. As such, it may vary widely between industries and companies.
Short-term nature. Diversifiable risks often have shorter time horizons and are more controllable or manageable by companies.

Diversifiable risk is specific, localized, and manageable through diversification. By spreading investments across different sectors, regions, and asset classes, investors can significantly reduce or eliminate this type of risk, focusing instead on managing the systematic risk inherent in all investments.

Example of Diversifiable Risk

As an example of diversifiable risk, you have invested all of your excess cash - $250,000 - in the the stock of one company, Magic Broom, which promises to bring to market an actual flying broom that can be used in Quidditch matches. Since you have invested everything in one stock, you are subject to a high degree of diversifiable risk, because any negative event relating to Magic Broom, such as the failure of its core product, will result in a decline in its stock price, and therefore the value of your stock portfolio.

If you were to instead spread you investment among several dozen companies, and preferably not ones that are all engaged in the production of gear for Quidditch matches, your diversifiable risk would decline dramatically. This would be especially the case if you were to invest across a multitude of industries, such as pharmaceuticals, railroads, power generation, and food production. The result would be a vastly higher level of diversification, so a major issue with one company would not have an excessive impact on your portfolio.