Non-diversifiable risk, also known as systematic risk, refers to the inherent market risks that cannot be eliminated through diversification, such as economic recessions, political instability, or interest rate changes.
Non-diversifiable risk represents the portion of investment risk that affects the entire market or asset class. Unlike diversifiable risk, which can be mitigated by holding a variety of uncorrelated assets, non-diversifiable risk stems from factors that influence all securities simultaneously. Examples include macroeconomic events, geopolitical shifts, inflation, and changes in monetary policy. Often referred to as systematic risk, this type of risk is unavoidable and impacts virtually all investments regardless of the amount of diversification within a portfolio. In financial theory, non-diversifiable risk is contrasted with unsystematic risk, which is company or industry-specific. Understanding non-diversifiable risk is essential for portfolio construction and risk management since it determines the baseline volatility and potential downside inherent in market exposure. Wealth managers use metrics such as beta to measure how sensitive a particular asset or portfolio is to overall market movements, reflecting its exposure to non-diversifiable risk.
Non-diversifiable risk matters because it sets the fundamental limit to risk reduction via diversification. Investment strategies must account for this inherent market risk when setting return expectations, asset allocation, and risk tolerance levels. It influences the design of portfolios that balance exposure to systematic risk factors against the desire for growth and income. For family offices and wealth managers, understanding and quantifying non-diversifiable risk improves investment reporting and governance by clarifying which risks are controllable and which are not. It also informs tax planning and liquidity management, ensuring that risk premiums for bearing market-wide risk are appropriately compensated in strategic allocation decisions.
Consider a portfolio invested 100% in the stock market. During an economic recession, the overall market declines by 15%. This loss reflects non-diversifiable risk since it affects all stocks uniformly. Even if the portfolio holds hundreds of companies, it cannot avoid this systematic downturn. Conversely, if a single company's stock falls due to a scandal but the market is stable, that loss is due to diversifiable risk.
Non-Diversifiable Risk vs. Unsystematic Risk
Non-diversifiable risk (systematic risk) affects the entire market and cannot be eliminated through diversification, while unsystematic risk (also known as diversifiable risk) relates to individual securities or sectors and can be reduced by holding a diversified portfolio. Investors bear non-diversifiable risk as the price of market participation, whereas unsystematic risk is considered avoidable.
Can non-diversifiable risk be eliminated by holding a large number of investments?
No, non-diversifiable risk cannot be eliminated regardless of portfolio size or diversification because it stems from market-wide factors affecting all assets simultaneously.
How is non-diversifiable risk measured?
It is commonly measured by beta, which indicates how much an asset or portfolio moves relative to the overall market. A beta greater than 1 implies higher exposure to non-diversifiable risk.
Why should investors care about non-diversifiable risk?
Because it represents the baseline level of risk that investors cannot avoid, understanding non-diversifiable risk helps in setting realistic expectations for returns and in designing suitable investment strategies.
