Diversifiable Risk Definition & Diversifiable Risk Example
Diversifiable Risk Definition
Diversifiable Risk is the risk that a company can take to reduce its overall risk. A company with diversifiable risk will have a limited amount of exposure to any one type of financial or business uncertainty. The company will have to take on other types of risk or diversify.
Diversifiable risk is the risk that can be removed from an investment portfolio and diversified away. Diversification is the process of constructing a portfolio of assets so that the risk of decline in any one asset is offset by the performance of other assets. Diversified investments are less risky and less volatile than non-diversified investments.
A company with diversifiable risk will have a limited amount of exposure to any one type of financial or business uncertainty. The company will have to take on other types of risk or diversify.
Diversifiable Risk Example
Diversifiable risk is the type of risk that can be reduced by diversifying your investments.
For example, if you invest in stocks and bonds, a downturn in one market will not affect the other. This type of risk is also called systematic or non-diversifiable
Another example of the concept is that a person who owns all Apple stock has unlimited liability for his investments and is exposed too much to the negative results if Apple as a whole does not do well.
If, on the other hand, that person owned a portfolio of financial instruments from a wide variety of companies, his risk exposure would be limited to the uncertainty of the financial sector. If one company does not do well, he will not lose money because he owns many companies.
Types of Diversifiable Risk
There are two types of diversifiable risks:
- Unsystematic risk
The type of risk determines if it is diversifiable or not.
Systematic risk is defined as all non-diversifiable risk. This type of risk includes macroeconomic risks, which is the result of when economic activity across the globe slows down or overheats, affecting all businesses.
Unsystematic risk is a risk that cannot be mitigated through diversification. It is also known as company-specific or diversifiable risk. This type of risk includes external market risks such as when a company launches a new product and fails to obtain customer acceptance.
Unsystematic risks are caused by external events, which are unpredictable. These events can have a significant, unforeseen, negative impact on the project.
How is Diversifiable Risk determined?
Diversifiable risk is determined by analyzing a company’s assets and liabilities. The balance sheet shows the company’s exposure to risk through a range of variables like assets, liabilities, equity, and income. Once the firm’s diversifiable risk is determined, it can be assessed for its overall wealth or capital.
To determine if a company has diversifiable risk, one needs to determine how much of its worth can be attributed to illiquid market investments versus its tangible financial worth.
Factors can determine a company’s true diversifiable risk
The following factors can determine a company’s true diversifiable risk:
Financial assets: the total value of financial assets owned by the company. This includes cash, bonds and stocks.
Liquid assets: the total value of liquid securities such as bank accounts and cash.
Fiscal year-end: the fiscal year will determine which part of its costs will be deducted from taxable earnings. These include things like office, property taxes, maintenance expenses, etc.
Inventories: the amount of inventory that company has on hand.
Accounts receivable: the amount of money owed to the company by customers. If they have collected most of what is owed, they will be able to pay their expenses in cash.
Total assets: total assets minus total liabilities give a net worth for the company. This figure can determine if a firm has diversifiable risk. If its net worth is high, it does not have much diversifiable risk. On the other hand, if its net worth is low, it has a lot of diversifiable risks.
What are the indicators of Diversifiable Risk?
Diversifiable risk can be analyzed by looking at the intangibles and tangible values of a company’s assets and liabilities. The following indicators can help determine if a firm has diversifiable risk:
Uncertainty in sales; for example, how much money does the product requirements to be sold. If sales are low or uncertain, it will have less liquidity.
Operating results; if they are positive, it means the company is generating more cash than expenses. It can generate additional funds through sales and gains on investments.
The firm’s cash flow and income statement: income statement shows net income, which is primarily generated through sales of products or services. A high net income is a good indicator of diversifiable risk because it can determine the amount of money that will be used for debt payments or reinvestment in other companies.
Diversifiable Risk: Company-specific risk factors
The following company-specific risks should be analyzed in order to calculate the amount of diversifiable risk a firm takes:
Product or service failure rate; if a product or service is failing, it can negatively affect sales. Furthermore, this will lower the firm’s net income. The more fail cycles, the higher the company’s risk of bankruptcy.
Customer reaction to change; if customers are not pleased with new products or services, they may discontinue using them.
Workplace security; if a firm wants to lower its risk, it can hire security guards. They can prevent theft and lower the possibility of lawsuits.
Service delivery model; this is what determines the company’s cost structure, including salaries of service personnel, design fees, and maintenance costs. It is also important because it shows how much money can be saved through outsourcing or offshoring.
Industry growth; if the industry gets saturated, a company can raise prices or lower its product prices. This will make it difficult to sell more products.
Customers’ perception of quality, service, and value; customers will determine whether they will be loyal to a brand or not. If they perceive the firm’s products or services as poor, then there is a high possibility that they will stop using them.
Industry trends; for example, if a firm is in a market that uses an aging technology, it can be forced to search for better technology or face bankruptcy.
Economic factors; economic factors like inflation will make it costly to maintain and operate a business. The more costs, the more difficult it is to generate additional revenue through sales.
Competition; the amount of competition in a given marketplace has an effect on diversifiable risk and financial risk. If there is high competition, there are many parties competing for customer loyalty. As a result, customer prices may be low.
Risk Factors Affecting Diversifiable Risk
here are several industries that are associated with diversifiable risk factors. These include:
Manufacturing; manufacturing has an element of risk because it requires raw material suppliers and managers who can oversee production processes. It also has transportation costs, which make inventory management difficult. If a firm does not have enough inventory, it will risk losing customers. If it has extra inventory, it will lose money because of the cost of maintaining and storage.
Service; the service industry requires more human labor compared to other businesses. Because of this, there is a substantial amount of diversifiable risk that can affect customer loyalty. Some customers may not be pleased with service delivery practices and they will discontinue using them.
Construction; this industry involves a lot of human labor and is considerably more exposed to risks like the economy, government regulations, and weather. Construction projects are also subject to delays due to changing deadlines and design issues.
Research and development; this industry has greater exposure to diversifiable risk because it requires costly investments in new products, machinery, and other assets. It also has failure rates that can be as high as 90 percent. If research fails, it is impossible for the company to recover from it.
Because of the lack of predictability, research organizations need to focus on improving their methodology for success rate. They also need to continuously update their process because it can take a long time for one project to be finished successfully.
Infrastructure integration; it is difficult to integrate companies that have a different number of products and services. It involves a lot of planning and coordination between businesses. If the integration fails, it can cause diversifiable risks for the company.