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What is an Undiversifiable Risk?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 10 September 2016
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    Conjecture Corporation
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Undiversifiable risks are the common risks that are associated with the rate of fluctuation or change that takes place in any given investment market. While a certain degree of undiversifiable risk is considered to be part of the normal process of engaging in the buying and selling of stock options, many analysts recommend a balance between assets and liabilities as a means of minimizing the amount of market risk involved with any investment strategy.

One of the most common methods of achieving this balance in relation to undiversifiable risk is to recognize the nature of the investment market. At any given point in time, some investments will be rising in value, while others remain stagnant or are in a period of decline. The principle of systematic risk involves balancing the elements of the portfolio so that gains with one investment helps to offset the temporary loss incurred with another investment. In order to manage this process, the investor would want to diversify the investments that make up the portfolio, so that they represent a broad range of investment types associated with a number of different industries.

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This process helps to manage the cumulative amount of undiversifiable risk by effectively buffering the investor against a net loss in the overall value of the portfolio. A buffer of this type also helps to buy the investor some time, in that the net worth of the portfolio does not suffer a great deal while decisions are made about what to sell and what to hang on to until the current downward trend reverses. In the event that a given stock or option is anticipated to bottom out and begin to recover in the short term, the investor may choose to hold onto the option and incur the loss.

In short, undiversifiable risk is not something that can be avoided altogether. At any given point in time, investors are working with the consequences of undiversifiable risk. Fortunately, the risk can be contained and controlled to a great degree by managing the portfolio efficiently and with an accurate assessment of upcoming market trends.

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