highly correlated. Clearly, increasing the number of securities from 30 to 100 does not
necessarily improve the diversification substantially.
Diversifiable and Non-Diversifiable Risk
We saw earlier that diversification reduces risk but does not eliminate it. We saw that
even the most well diversified portfolio that we can think of is subject to the risk arising
from fluctuations in the market index itself. This risk is known as market risk. Since all
securities move with the market to some extent, this is a risk which no amount of
diversification can eliminate. We now turn to a more detailed analysis of market risk and
its implications for portfolio theory.
The riskiness of each security can now be divided into two components: the market
related risk which cannot be diversified away at all, which is called non-diversifiable or
systematic risk and another component which can be eliminated through diversification,
called diversifiable or unsystematic risk. Let us see how these two components of risk
arise.
Unsystematic risk may be regarded as the extent of variability in the security’s return on
account of firm specific risk factors. This is also called avoidable risk because it is
possible to eliminate or diversify away this component of risk to a considerable extent by
investing in a portfolio of large number of securities, say 15 or more. This because, the
firm specific risk factors are mostly random. For example, if the management of one
company in the portfolio is poor, the management of another company in the portfolio
may be very good; at a given point of time if the productivity in one company is low, that
of another may be high and so on, so that by including sufficient number of securities in a
portfolio, such factors tend to cancel out the effect of each other. Similarly, the risk
arising out of industry specific factors can be eliminated by diversifying across several
industries.
However, the systematic factors cannot be diversified away completely. This is because
these factors affect the entire market in a certain direction. For example, a steep increase
in the international crude oil prices is almost certain to affect the entire market adversely.
Hence no amount of diversification can make a portfolio totally free from such risk, even
though diversification may reduce this risk up to a point. Therefore, this level of
systematic risk below which the riskiness of a portfolio cannot be reduced is also called
unavoidable risk.
Capital Asset Pricing Model.
We have described how investors trade off risk for reward. What is the exact nature of
this trade off? How much reward is sought by the investors for a unit of risk? Which
risk is relevant in the context of this trade off? The entire risk? The non-diversifiable
risk? Diversifiable risk? How does one measure non-diversifiable and diversifiable risk?
What is the role of diversification in the context of portfolio selection? These and other