What Types of Risk Cannot Be Reduced by Portfolio Diversification?

Portfolio diversification is a basic tenant of any good risk management strategy. However, there are some risks that portfolio diversification can not improve on. It’s important to be aware of the limitations of portfolio diversification and the risks that a portfolio will face no matter how well diversified it is. This article will dig into the types of risk that can’t be reduced by portfolio diversification.

Systematic Risk

Investors cannot reduce some risks through diversification. These risks are called systematic risks. Systematic risk is inherent to the entire market, which means it is always present. Systemic risk is also called undiversifiable risk.

Some examples of systematic risk include interest rate changes, inflation, war, and recessions. These risks fall into broad categories known as geopolitical and economic risks.

Why can’t systematic risk be diversified away? Diversification relates to smaller idiosyncratic risks within the market rather than the inherent risk of the broader market. These smaller risks are company, sector, and industry risks. 

For example, an investor holds 70% of his portfolio in automotive stocks. That is a concentrated risk. The investor improves portfolio diversification by reducing automotive stock holdings to 20% and bringing in other non-related sectors. This is only possible because the investor is diversifying unsystematic risk.

Another way of stating the same thing is that the investor has reduced risk in the portfolio to the automotive sector and spread portfolio risk across several sectors. 

Idiosyncratic risk is the risk of a single company or stock. A portfolio that holds equal proportions of four companies may have high idiosyncratic risk. If one company fails, 25% of the portfolio may become worthless. By adding 15 more companies from different industries, the portfolio reduces idiosyncratic risk from 25% to 5% (1/20).

In theory, to answer the above question, we can’t predict when war will break out or when inflation will suddenly take off. Some will say you can see a war brewing or inflation starting to rise and take appropriate action to readjust a portfolio. Perhaps, but the point about systematic risk is that it is unpredictable.

Does Diversification Work?

Diversification does work as a risk improvement against idiosyncratic risk within an industry or company. It doesn’t work to improve systematic risk.

Diversification works through assets with low or negative correlation. Stocks or properties that aren’t correlated don’t depend on related factors as those that are correlated. 

For example, an investor’s portfolio comprises three properties in the same section of town. That area of the town begins experiencing an economic decline, and property values drop. The investor’s portfolio will likely experience a decline with nothing to offset it.

Another investor owns two properties in that same area of town and three properties in three different cities. One of those three properties is rising faster than all others. Assuming all properties are similar proportions of the portfolio, the decrease in the two properties will be partially offset by the increase in the one property. Additionally, the two decreasing properties are only 40% of the portfolio rather than 100%. 

The above diversified portfolio won’t experience the same adverse impact as the first portfolio. That’s because uncorrelated properties are helping to decrease the portfolio’s volatility.

Diversifying through geographic location and industry type helps improve volatility within a real estate portfolio. Properties located in different cities with different economies are uncorrelated. Properties in different industries (i.e., residential, office, warehouse, industrial space, mini storage) are also uncorrelated.

While investors can’t diversify systematic risk away, investors should not give up on diversification. Investors can still improve idiosyncratic risk through diversification.