Types of Risk – Systematic & Unsystematic Risk
In investing, knowing the types of risk is key to making informed decisions and managing your portfolio. There are two main types of risk that investors need to be aware of are systematic risk and unsystematic risk. Each type of risk affects investments differently and requires different solutions. Let’s break down both.
What is Systematic Risk?
Systematic risk (also known as market risk or non-diversifiable risk) affects the whole market or a big chunk of the market. This type of risk is inherent to the market and cannot be diversified away.
Systematic risk is caused by things like economic changes (recessions, inflation, interest rates. For example a recession can cause corporate earnings to decline and stock prices to fall), political events (elections, policy changes, geopolitical events. Can create uncertainty and volatility), natural disasters (earthquakes, hurricanes, pandemics. Disrupts economic activity and market stability).
Systematic risk can’t be diversified away, so investors manage it through asset allocation and hedging.
- Asset Allocation: Spreading your investments across different asset classes like stocks, bonds and real estate can reduce the impact of systematic risk on your portfolio. Different asset classes react differently to market events so there’s some protection.
- Hedging: Using financial instruments like options, futures and derivatives can help you protect your portfolio from market downturns. For example buying put options can protect you if the market goes down.
The types of systematic risk are:
1. Interest Rate Risk
When interest rates change, investments move in the opposite direction. And the rate at which you can re invest also changes. For example, when interest rates rise, existing bonds decrease in value as new bonds are issued with higher rates.
2. Inflation Risk
Inflation risk is when the purchasing power of money decreases due to rising prices. This is the main reason why interest rates change, as investors adjust their expectations for inflation. High inflation can eat into your real returns.
3. Liquidity Risk
Liquidity risk is the difficulty of converting investments into cash quickly at a fair price. Some assets like real estate or thinly traded stocks can be hard to sell quickly without affecting their price.
4. Maturity Risk
Long term investments react more to interest rate changes than short term bonds. The longer the maturity of an investment, the more sensitive it is to interest rate changes.
5. Exchange Rate Risk
Multinational companies that deal with different currencies face exchange rate risk. The value of these currencies can fluctuate due to market conditions and affect the company’s revenues and expenses when converted back to their home currency.
6. Political Risk
Government actions like changes in regulations, taxation or political instability can reduce the value of investments. Political risk can affect domestic and international investments.
What is Unsystematic Risk?
Unsystematic risk, also known as specific risk or diversifiable risk, is company or industry specific. Unlike systematic risk, unsystematic risk can be reduced or eliminated by diversification.
This type of risk is caused by company or industry specific factors such as management decisions (poor strategic decisions, unethical practices, or leadership changes can negatively impact a company’s performance and stock price), product recalls(defective products or safety issues can lead to recalls, damaging a company’s reputation), regulatory changes (new regulations or changes in existing laws can affect a specific industry, leading to increased costs or reduced profitability), and competitive pressures (iIncreased competition can erode a company’s market share and profitability).
Diversification is the primary method to manage unsystematic risk. Invest in lots of companies and industries and if one goes bad, it won’t affect your portfolio as much.
- Diversification: Stocks, bonds, all that stuff. One investment bad, the others will buffer that.
- Research and Analysis: Do your research and analysis before you invest and know what can affect a company or industry and that will help you decide.
The types of unsystematic risk are:
1. Business Risk
This risk is inherent in the business if the company has no debt. Factors like product safety, management quality and labour conditions affect firm specific risk. For example, a company with poor management decisions or labour disputes can face operational challenges that impact its financial performance.
2. Financial Risk
Financial risk is related to how the company is financed. This includes debt levels and financial structure. High debt levels can increase financial distress risk as the company needs to generate enough cash to meet its debt obligations.
3. Default Risk
Default risk is part of financial risk that reflects the probability the company will not be able to service its existing debt. If a company can’t make its interest payments or repay its debt, it will default and can go bankrupt. Investors need to assess the company’s creditworthiness to understand its default risk.
4. Management Decisions
Poor strategic decisions, unethical practices or leadership changes can impact the company’s performance and stock price. For example, the company decides to enter a new untested market and it fails.
5. Product Recalls
Defective products or safety issues can lead to recalls that damage the company’s reputation and financial health. A high profile recall can cost the company a lot and lose customer trust, impacting future sales and profitability.
6. Regulatory Changes
New regulations or changes in existing laws can impact a specific industry and increase costs or reduce profitability. For instance, stricter environmental regulations can require companies to invest in new technologies that impact their bottom line.
7. Competitive Pressures
Increased competition can erode the company’s market share and profitability. New entrants to the market or innovative products from competitors can challenge the company’s position and force it to lower prices or increase spending on marketing and innovation.
The Bottom Line
Knowing the types of risk – systematic and unsystematic – is key to good portfolio management and investment decisions. Systematic risk affects the whole market and can’t be diversified away but can be managed through asset allocation and hedging. Unsystematic risk is company/industry specific and can be diversified away. By understanding and managing these risks investors can protect their portfolios better and achieve their financial goals.
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