Q6. Why is it reasonable to ignore d... [FREE SOLUTION]

Chapter 17: Q6. (page 368)

Why is it reasonable to ignore diversifiable risk and care only about non-diversifiable risk? What about investors who put all their money into only a single risky stock? Can they properly ignore diversifiable risk?

Short Answer

Expert verified

The diversifiable risk can offset the good and bad effects causing no harm to the investor. But the non-diversifiable risk is unable to do such offset. So, one can ignore diversifiable risk and worry about non-diversifiable risk.

The investors who put all their money into a single risky stock can properly ignore diversifiable risk.

Step by step solution

Step 1. Diversifiable and non-diversifiable risk

For example, an investor has a diversified portfolio investment in two companies. One company is giving good returns; the other is giving bad returns. Both the returns will cancel out each other, and the investor will not get profit or loss. The risk taken by such an investor is the diversifiable risk. When the risk is non-diversifiable, such offsetting does not happen, and the investor faces a loss. So, the non-diversifiable risk can not be ignored.

Step 2. Investing in a single risky stock

The investors who put all their money into a single risky stock can properly ignore the diversifiable risk because they do not face it, but they face the non-diversifiable risk.