Question

6. What is the difference between diversifiable and non-diversifiable risk? If a portfolio is sufficiently well diversified the most that you can expect it will generate is a market return as its overall risk will also be equivalent to a market level of risk. Explain why this is true

Answer 1

The difference between diversifiable and non-diversifiable risk is, as the name suggests, that the diversifiable risk or the idiosyncratic risk of a company can be removed by diversifying your portfolio but the non-diversifiable risk can't be. This is because diversifiable risk is the risk unique to a company and hence when we take positions in a lot of companies and industries they tend to cancel each other and what remains is the portfolio almost representing the market.

This statement is true because when we have diversified the portfolio enough, we reach the point where our portfolio is nothing but a market portfolio. This is because the risk present in the market is non-diversifiable risk and by diversifying sufficiently well, we remove all the diversifiable risk and what remains is just the non-diversifiable risk.