Non-Diversifiable Risk
Definition:
Non-diversifiable risk, also known as systematic risk, refers to the risk inherent in the entire market or a particular asset class and cannot be eliminated through diversification. It is influenced by external and macroeconomic factors affecting the overall market.
Characteristics of Non-diversifiable Risk:
Market-wide Impact: This risk affects the entire market or a specific asset class, and its impact is felt across various securities.
Influential Factors: Systematic risk is driven by broader economic factors such as interest rates, inflation, political events, and market volatility.
Types of Systematic Risk:
Interest Rate Risk: Fluctuations in interest rates impacting bond prices and borrowing costs.
Inflation Risk: Reduced purchasing power due to rising inflation affecting asset values.
Economic Risk: Market fluctuations influenced by economic cycles and business conditions.
Significance of Non-diversifiable Risk:
Unavoidable Nature: Unlike unsystematic risk, which can be mitigated through diversification, systematic risk impacts the entire market and cannot be eliminated.
Portfolio Evaluation: Understanding and accounting for systematic risk is crucial in making informed investment decisions.
Example:
In a situation where interest rates rise, the entire bond market experiences a decline in value, impacting all bond investments, irrespective of individual bond qualities or issuer-specific factors.
FAQ's
How does non-diversifiable risk differ from diversifiable risk?
Diversifiable risk, or unsystematic risk, can be reduced by diversifying across different assets, while non-diversifiable risk affects the market as a whole and cannot be mitigated through diversification.
Can systematic risk be hedged against?
While diversification is not effective against systematic risk, some financial instruments like derivatives or options can offer certain hedging strategies.
Are all macroeconomic factors examples of non-diversifiable risk?
Many macroeconomic factors contribute to systematic risk, but not all macroeconomic events necessarily result in non-diversifiable risk.
How does systematic risk impact an investment portfolio?
Systematic risk affects the overall value of an investment portfolio as it cannot be diversified away, thereby influencing the entire market or asset class.
Conclusion
Non-diversifiable risk, or systematic risk, constitutes the market-wide risk factors impacting all securities in a particular market or asset class. Understanding and accounting for systematic risk is essential in assessing and managing investment portfolios.