What it means
Investment risk splits neatly into two parts. One part is unique to the individual asset and is variously called diversifiable, unsystematic, specific or idiosyncratic risk; the other moves with the whole economy and is called systematic or market risk.
Only the first part disappears as you add more holdings. The mechanism is straightforward.
Good and bad company-specific surprises are largely independent of one another, so in a portfolio of forty unrelated shares one company's disastrous quarter is often cancelled out by another's unexpectedly strong one. Add enough independent holdings and the specific shocks average close to zero.
This has a sharp practical consequence for how returns are set. Because investors can remove diversifiable risk almost for free, markets do not reward them for bearing it, and expected return is priced from systematic risk alone.
That is the reasoning behind beta and the capital asset pricing model. Most of the benefit arrives quickly.
Moving from one holding to ten cuts specific risk dramatically, from ten to thirty helps noticeably, and beyond about thirty carefully chosen holdings the improvement becomes small. Genuine diversification also depends on the holdings being different from each other, since thirty regional banks are far less diversified than they appear.
Business owners and employees face the same issue in a less obvious form. A founder with most of their wealth in one company, or an employee holding a large stake in their own employer, is carrying a great deal of diversifiable risk without being paid for it.
Selling down over time is the standard remedy.
In practice
Real-world examples.
Example
A pharmaceutical company's shares fall 30% in one day when a trial fails. An investor holding it as 2% of a diversified portfolio loses 0.6% overall, while an investor who held only that company loses nearly a third of their money.
Example
A pension trustee reviews a fund that holds twenty-five shares, of which eighteen are oil and mining companies. The adviser points out that the portfolio looks diversified by count but is really one bet on commodity prices, so much of the specific risk remains.
Example
A software founder receives an offer to sell 20% of her holding in a secondary transaction. Her adviser recommends accepting, because concentrating both her salary and her entire net worth in a single private company is diversifiable risk she is not being compensated for.
Think of it
“Diversifiable risk is risk you can eliminate by owning many investments-company-specific issues that wash out.
Formula
Calculation
Total variance = systematic variance + diversifiable variance, where systematic variance = beta squared x market variance.
Take a single share whose returns have a standard deviation of 30% a year, so its total variance is 0.30 x 0.30 = 0.09. The market's standard deviation is 15%, giving a market variance of 0.0225, and the share has a beta of 1.2.
Its systematic variance is 1.2 x 1.2 x 0.0225 = 1.44 x 0.0225 = 0.0324. The diversifiable variance is therefore 0.09 - 0.0324 = 0.0576, and the square root of 0.0576 is 0.24, or 24%. In other words 0.0324 / 0.09 = 36% of this share's risk is market risk that cannot be diversified away, and the remaining 64% can be.Case study
Seen in the real world.
Brayford Mutual is an illustrative, fictional investment club invented to demonstrate the arithmetic of diversification. In this hypothetical case its twelve members originally pooled their money into just three shares, all suppliers to the same car manufacturer, on the reasoning that they understood the sector well.
When that manufacturer delayed a model launch, all three holdings fell together and the club lost 28% in a quarter. A member with a finance background showed that the portfolio's specific risk had barely been reduced at all, because the three holdings shared one dominant customer and therefore moved almost as one.
The fictional club rewrote its rules to require at least twenty holdings across a minimum of six unrelated sectors, with no single position above 8%. Over the following years its results tracked the wider market far more closely, which was precisely the intention.
Watch out
Common mistakes.
- Believing that owning many holdings is automatically diversification. If the holdings respond to the same underlying driver, such as one commodity or one customer, their specific risks do not cancel out.
- Expecting a higher return for taking concentrated positions. Markets pay for systematic risk, so an undiversified investor takes extra risk without any extra expected reward.
- Thinking diversification protects against market crashes. It removes company-specific risk only; in a broad downturn nearly everything falls together.
Questions
People also ask.
How many holdings are enough?
Research generally suggests most diversifiable risk disappears with roughly twenty to thirty genuinely unrelated holdings, with limited benefit beyond that.
Is diversifiable risk the same as unsystematic risk?
Yes. Diversifiable, unsystematic, specific and idiosyncratic risk are four names for the same idea, and analysts use them interchangeably.
Does diversification reduce expected return?
Not in itself. It reduces the variability of outcomes while leaving the expected return roughly equal to the weighted average of the holdings.
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