How are total risk,nondiversifiable risk, and diversifiable risk related Why is nondiversifiable risk regarded as the only relevant risk – Essay Example

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How are total risk, nondiversifiable risk, and diversifiable risk related? Total risk is a combination of all potential risk factors that are associated with making investment decisions. According to capital asset pricing model, total risks involve both systematic and unsystematic risks involved in either selling or buying a given investment portfolio. The standard deviation is used to measure total risk since it captures the degree of variability of expected outcomes. When determining the total risk of an investment portfolio, it is assumed that the investment has both diversifiable and non diversifiable risks although this is not the case since some investments have only one category of the risks. Diversifiable risks These are risks that are specific to a given sector or security to its effect on a diversifiable portfolio. The risks that are diversifiable depend on the specific investment that is assessed. These risks can be reduced through diversification. It can be attributed to specific firm events such as regulation actions, strikes, law suits, and loss of investment portfolio. This risk can be influenced by the investor, and therefore; they are easy to mitigate. Their impact on an investment is extremely severe if it is not mitigated. These are the most common risks in and they have incredibly significant effect on the degree of non diversifiable and total risks. Non diversifiable risk. These are risks that are common to an entire group of assets and liabilities. All investments have non diversifiable risks, and their impact is insignificant compared to the impact of the diversifiable risks. The investor has no control over these risks, and there fore exceedingly difficult to measure and mitigate them. There are no clear methods that are used to identify or mitigate these risks. Diversification can be used although it effect is insignificant. For the case of non diversified risks, the assets whose returns are negatively related with wider market returns have high prices. Both diversifiable and non diversifiable risks are main factors to consider when assessing the degree of total risk in an investment portfolio. Diversified risks will look closely to any risk inherent to a particular group of investment. On the other hand, non diversified risk will focus on the general risks that are associated to given investment portfolios. For total risks, the entire risks involving the specific investment and the industry are dreadfully paramount to determine the portfolio to invest. Why is nondiversifiable risk regarded as the only relevant risk? Non diversifiable risks are those risks that are common to a whole class of assets and liabilities. The value of an investment may change in a short period of time due to the economic changes and other underlying factors. The non diversifiable risks have significant effects on the market. Diversification can be used to hedge against the risk although most investment are most likely to under perform. Non diversifiable risks being non-compensating and unavoidable are considered as significant risks attributed to the market factors influencing the firms. The major causes of these risks are inflation, international incidents, war and political measures. This risk is beyond the investor control, and it is difficult to control. The non diversified risks are identified through estimation and analysis of the relationships between the different portfolios through the principal component analysis. There is no specific method that can be used to identify and mitigate the non diversifiable risks due to their impact on the entire market. Wrapping up, different choices on investments regarding if to invest or not are made based on the degree of the risks. An investor will choose a portfolio that has minimum risks and whose returns are relatively high. This investment should have few diversifiable risks that are mitigated and few non diversifiable risks. This will imply that the investment has few total risks. Reference Malevergne, Yannick, and Didier Sornette. Extreme financial risks from dependence to risk management. Berlin: Springer-Verlag, 2006. Print.

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