Question

Briefly define and give examples of diversifiable risk and non-diversifiable risk. Which is the relevant risk and why? (1–2 paragraphs)

Answer 1

Diversifiable risks are firm-specific risks such as strike, fraud, litigation etc. These risks can be reduced by adding multiple assets in the portfolio which are not perfectly correlated.

Non-diversifiable risks affect the whole market for example Inflation, financial crisis etc. These risks cannot be reduced by diversifying the portfolio.

Since diversifiable risk can be reduced by creating a diversifiable portfolio and anyone can prepare such a portfolio and hence reduce the diversifiable risks to zero. Whereas non-diversifiable risk cannot be reduced and hence non-diversifiable risk is the relevant risk.