Diversification and Unsystematic Risk

From our discussion of portfolio risk, we know that some of the risk associated with individual assets can be diversified away and some cannot. We are left with an obvious question: Why is this so? It turns out that the answer hinges on the distinction we made earlier between systematic and unsystematic risk.

By definition, an unsystematic risk is one that is particular to a single asset or, at most, a small group. For example, if the asset under consideration is stock in a single company, the discovery of positive NPV projects such as successful new products and innovative cost savings will tend to increase the value of the stock. Unanticipated lawsuits, industrial accidents, strikes, and similar events will tend to decrease future cash flows and thereby reduce share values.

Here is the important observation: If we only held a single stock, then the value of our investment would fluctuate because of company-specific events. If we hold a large portfolio, on the other hand, some of the stocks in the portfolio will go up in value because of positive company-specific events and some will go down in value because of negative events. The net effect on the overall value of the portfolio will be relatively small, however, because these effects will tend to cancel each other out.

Now we see why some of the variability associated with individual assets is eliminated by diversification. When we combine assets into portfolios, the unique, or unsystematic, events—both positive and negative—tend to "wash out" once we have more than just a few assets.

This is an important point that bears repeating:

principle of diversification

Spreading an investment across a number of assets will eliminate some, but not all, of the risk.

Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.

In fact, the terms diversifiable risk and unsystematic risk are often used interchangeably.

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