InvestorQ : Does diversification help me to remove all kinds of risk in my investment portfolio?
Anjana Aiyar made post

Does diversification help me to remove all kinds of risk in my investment portfolio?

Deepa Salunkhe answered.
3 years ago

The first thing to understand is that there is nothing like riskless investing. All investments (including government bonds) carry some form of risk. Even after diversification, there is some element of risk that still remains in your portfolio. However, to buttress this point better, let us understand the two specific kinds of risk. Understanding these risks is fundamental to your understanding of diversification and why it is limited after some time.

In stock markets we divide risk into systematic risk and unsystematic risk. Unsystematic risk is unique to assets or sectors or themes and can be reduced by diversifying to other asset classes. When we talk of risk reduction through diversification, we always talk of unsystematic risk; and that is why it is also called diversifiable risk. The second type of risk is systematic risk which stems from macro factors like inflation, currency, capital flows etc. You really cannot reduce your portfolio’s systematic risk by diversifying because macro level risks are going to impact most of your stocks in much the same way. Effectively, diversifying risk only refers to reducing our unsystematic risk and that reduces the overall risk in the process. Systematic risk still remains in your portfolio, irrespective of what you do. The only thing you can do about systematic risk is to try and hedge with Nifty Futures.

Here are some key points for you to understand. Firstly, systematic risk remains constant through the stock additions even when you diversify across asset classes. Secondly, even unsystematic risk cannot really be reduced to zero because some element of unsystematic risk will remain in your portfolio despite all your efforts at diversification. Lastly, adding more stocks works only up to a point. Beyond that, it only leads to substitution of risk.