Meaning and definition of non-diversifiable risk
Non-diversifiable risk can be referred to a risk which is common to a whole class of assets or liabilities. The investment value might decline over a specific period of time only due to economic changes or other events which affect large sections of the market. However, diversification and asset allocation can provide protection against non-diversifiable risk as different sections of the market have a tendency to underperform at different times. Non-diversifiable risk can also be referred as market risk or systematic risk.
Putting it simple, risk of an investment asset (real estate, bond, stock/share, etc.) which cannot be mitigated or eliminated by adding that asset to a diversified investment portfolio can be delineated as non-diversifiable risks. Moreover, this is the risk you are exposed to in an individual investment. This risk type is involved in almost every investment, i.e. uncertainty of market moving up or down and the particular movement of the investment.
Understanding non-diversifiable risk
Being unavoidable and non-compensating for exposure to such risks, non-diversifiable risk can be taken as the significant section of an asset’s risk attributable to market factors affecting all firms. The main reasons for this risk type include inflation, war, political events, and international incidents. Moreover, it cannot be purged through diversification.
Factors responsible for non-diversifiable risk
Non-diversifiable risk is an outcome of factors influencing the complete market like changes in investment policy, foreign investment policy, alterations in taxation clauses, altering of socio-economic parameters, global security threats and measures, etc. the non-diversifiable risk is not under the investors’ control and is also difficult to be mitigated to a large extent.
However, non-diversifiable risks are identified through the analysis and estimation of the statistical relationships between the different asset portfolios of the company through different techniques, including principal components analysis. There is no specific method that can be used to handle the non-diversifiable risk. This is due to their impact which is reflected on the entire market.
ConclusionWrapping up, therefore, different choices are made by investors regarding whether to agree to or not different investment options depending on the risk type involved in such investments. In case of a non-diversifiable risk, including inflation and wars, investors choose to invest in portfolios, like real estate, which involve lesser risk.