Diversifiable and undiversifiable risk in inflation and recession scenarios

Investor Diversification

Some investment assets have a diversifiable risk and some have an undiversifiable risk involved. Diversifiable risk is specific to a particular security or sector, so its impact on a diversified portfolio is limited to that particular security (moneyterms.co.uk). For example, a financial crisis in a country can cause diversifiable risk on the investments pertaining to the financial institutions. Undiversifiable risk is the tendency of stock prices to decrease, which is caused by something that affects returns on all stock in the same manner, such as war or an interest rate change (Legal).

A substantial unexpected increase in inflation would be an undiversifiable risk because it is common to an entire class of assets or liabilities, or all the stock on the market. It is also considered a market risk or a systematic risk. The economy expects prices to rise slowly over a period of time. That goes along with the economic growth. A substantial unexpected increase in prices can cause the sales in the economy to slow down because consumers may not view the product as having the value of the unexpected substantial increase in price. This activity affects the revenue in a company, which in turn, affects the stock prices.

A major recession in the economy is an undiversifiable risk because it affects the overall market conditions, more especially when unemployment is on the rise and spending is on a slowdown. Even though different parts of the market will have different affects from the recession, depending on the conditions that actually cause the recession, all the stock in the market are affected to some degree. This is another market risk when it comes to investments of stock and other high risk assets.

A major lawsuit against a large publicly traded corporation is a diversifiable risk because it is only against the stock of that specific corporation. Corporations usually expect lawsuits to a certain degree and allow for it in the budget, but a major lawsuit could have substantial damage, depending on the circumstances of the lawsuit. More especially corporations, such as Google, Inc., face this with the assets of patents. The stock prices of these corporations could be affected in major ways if another company wins a lawsuit on infringement of rights against Google, Inc. Or, if someone else tries to use the rights of the patents that are owned by Google, Inc., it could affect the stock price with the legal costs of the battle and the loss of sales resulting from the incident.

The expected rate of return on the market portfolio would be seven percent given that the expected rate of return on asset "i" is 12%, the risk-free rate is 4%, and the beta is 1.2. The risk free rate is four percent given that the expected rate of return on asset "j" is 9%, the expected rate of return on the market portfolio is 10%, and the beta is 0.8.

Determining the beta for a portfolio that contains half the stocks traded on the major exchanges would need to be determined based on the actual stock in the portfolio. Each individual stock beta would need to be involved in the calculation. Without knowing exactly what these individual stocks are, it is impossible to figure what the beta would be for the overall portfolio. Once the beta for each individual stock is determined, depending on what these stocks are, the beta can be figured for the overall portfolio. Determining how diversified the overall portfolio is would also depend on exactly what assets are in the portfolio and how risky each asset is compared to the market rate.

The Capital Asset Pricing Model is a tool that corporations and investors use to determine the diversity of an overall portfolio. The diversity of the portfolio tells how risky the overall investment portfolio is. Where some assets are more risky than others, corporations use hedging techniques to control the undiversifiable risks involved in the overall portfolio. Hedging is a means to strategically use instruments in the market to offset risk of adverse price movements, or hedging one investment by making another (Investopedia). Reductions in risk always mean a reduction in potential profits. Hedging reduces potential loss in a portfolio. Examples of hedging used by corporations are derivatives, such as options or futures.

The Capital Asset Pricing Model is used for each investment asset in the portfolio to determine the beta, or riskiness, of each asset. With the beta for each asset, the corporation can determine the overall riskiness of the entire portfolio. The betas are determined on a regular basis to determine how the riskiness fluctuates as the asset prices fluctuate. In this manner, a corporation can determine how the riskiness, or beta, for the overall portfolio changes and can make adjustments in the assets as necessary to control the overall risks involved.