Types Of Risk

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Types of Risk:

To understand the basic types of risk, consider what happens to the risk of a portfolio consisting of a single security (asset), to which we add securities randomly selected from, say, the population of all actively traded securities the standard deviation of return, kp, to measure the total portfolio risk, depicts the behavior of the total portfolio risk (y axis) as more securities are added (x axis). 

With the addition of securities, the total portfolio risk declines, as a result of the effects of diversification, and tends to approach a lower limit. Research has shown that, on average, most of the risk-reduction benefits of diversification can be gained by forming portfolios containing 15 to 20 randomly selected securities.

             The total risk of a security can be viewed as consisting of two parts: 

                    Total security risk = Nondiversifiable risk + Diversifiable risk



Diversifiable risk:

Diversifiable risk (sometimes called unsystematic risk) represents the portion of an asset’s risk that is associated with random causes that can be eliminated through diversification. It is attributable to firm-specific events, such as strikes, lawsuits, regulatory actions, and loss of a key account.

Examples of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, or a product recall. 



Nondiversifiable risk:

Nondiversifiable risk (also called systematic risk) is attributable to market factors that affect all firms; it cannot be eliminated through diversification. Factors such as war, inflation, international incident's, and political events account for Nondiversifiable risk.

Examples of systematic risks include:
  • Macroeconomic factors, such as inflation, interest rates, currency fluctuations.
  • Environmental factors, such as climate change, natural disasters, resource, and biodiversity loss.
  • Social factors, such as wars, changing consumer perspectives, population trends

 Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is Nondiversifiable risk. Any investor or firm therefore must be concerned solely with Nondiversifiable risk. The measurement of Nondiversifiable risk is thus of primary importance in selecting assets with the most desired risk–return characteristic.



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