Risk is the probability of an individual or organization incurring a loss. Risk can be classified as market risk, credit risk, operational risk, liquidity risk, and compliance.
In finance, the risk is the chance that the actual rate of return on an investment will be different from what was originally expected. An investor can assess how risky an investment is by looking at three factors: the amount of uncertainty in the underlying return, the degree of correlation to other investments, and the length of time until an investment matures.
Broad Categories of Risks in Finance
The deviation from the anticipated return is caused by is explained by 2 levels of risk: systematic risks and unsystematic risks. The sum of these two main categories of risk is the total risk to which an investor is exposed.
“Systematic risk” or “Risk” means a risk that is common to all possible courses of action and can be quantified for a specified set of circumstances. It includes risks to the financial integrity and long-term viability of the organization. Systematic risk is contrasted with “Unsystematic risk” or “Risk”. It is the risk arising from the inherent nature of a business. Unlike systematic risk, it cannot be precisely quantified. For example, inflation could increase the cost of a business. This would increase the cost of goods sold. However, this risk could be offset by increasing the selling price of the goods.
Systematic risk is associated with overall movements in the general market or economy and therefore is often referred to as the market risk. The market risk is the component of the total risk that cannot be eliminated through portfolio diversification.
These are also known as undiversifiable risks. Many academics believe that the reward for credit risk from the portfolio angle is the return for the systematic risk undertaken by the lenders (because all non-systematic risk can be diversified away).
Systematic risks are typically those that occur across an entire market, such as a recession. Unsystematic risks generally occur within a single company, for example, a company made a poor decision to refuse to produce goods that have been requested by consumers.
Examples of systematic risk
Economic downturns: Economic recessions or depressions can cause the overall market to decline, as businesses experience reduced profits and consumers cut back on spending.
Interest rate changes: Changes in interest rates can impact the value of stocks and bonds, as investors adjust their expectations for future returns.
Geopolitical events: Wars, political instability, and terrorist attacks can create uncertainty and risk aversion in the market, leading to declines in stock prices.
Natural disasters: Hurricanes, earthquakes, floods, and other natural disasters can disrupt supply chains, damage infrastructure, and cause widespread economic damage.
Managing systematic risk
Diversification: Diversifying across different asset classes, industries, and geographic regions can help to reduce the impact of systematic risk on an individual portfolio.
Asset allocation: Proper asset allocation based on an investor’s risk tolerance and time horizon can help to manage exposure to systematic risk.
Hedging strategies: Hedging strategies, such as using options contracts or futures contracts, can be used to offset potential losses from systematic risk events.
Active management: Active portfolio managers may attempt to identify and mitigate systematic risk through market analysis and forecasting.
Long-term investment horizon: Maintaining a long-term investment horizon can help to ride out periods of market volatility caused by systematic risk events.
It is important to note that systematic risk cannot be completely eliminated, but it can be managed through various strategies. Investors should consider their risk tolerance and investment goals when making decisions about how to manage systematic risk in their portfolios.
Unsystematic risks are the component of the portfolio risk that can be eliminated by increasing the portfolio size, the reason being that risks that are specific to individual security such as business or financial risk can be eliminated by constructing a well-diversified portfolio. These are known as diversifiable risks. One example of unsystematic risk is a C.E.O. resigning from the post. It is a company-wide issue, not the nation or economy-wide.
Unsystematic risk is the risk of loss that cannot be diversified away through investment in any of the securities in a broadly diversified portfolio. This non-diversifiable risk applies to all securities, and it has no bearing on the overall market cycle of an economy.
Examples of unsystematic risk
Company-specific events: Events such as a product recall, management changes, or legal disputes can affect the stock price of a particular company, while not impacting the overall market.
Industry-specific events: Events such as technological advancements, regulatory changes, or shifts in consumer preferences can affect the performance of an entire industry, but not the broader market.
Operational issues: Operational problems such as supply chain disruptions, production failures, or labor strikes can negatively impact a company’s financial performance, but not necessarily the performance of other companies in the same industry.
Accounting practices: Different accounting practices used by companies within the same industry can lead to variations in reported financial performance, which can affect investor perceptions and stock prices.
Managing unsystematic risk
Diversification: Diversifying across different companies, industries, and geographic regions can significantly reduce unsystematic risk. By holding a variety of investments, investors are less exposed to the specific risks of any single company or industry.
Research and analysis: Thorough research and analysis of individual companies and industries can help investors identify and avoid companies with high unsystematic risk.
Monitoring and rebalancing: Regular monitoring of portfolio performance and rebalancing as needed can help to maintain a diversified portfolio and reduce unsystematic risk over time.
Understanding company-specific factors: Investors should pay attention to company-specific factors such as management quality, financial strength, and competitive advantages to assess the potential for unsystematic risk.
Considering alternative investments: Investing in asset classes less correlated with stocks, such as bonds or real estate, can provide further diversification and reduce overall portfolio risk.
Unsystematic risk is an inherent component of investing, and it cannot be completely eliminated. However, by diversifying their portfolios and carefully selecting investments, investors can significantly mitigate unsystematic risk and improve the overall risk-return profile of their investments.