In my article “What is Investment Risk” I discuss the single risks which can appear when investing in the securities markets. That said, the article does not touch upon the fact that investment risk is divided into two broad categories: systematic and unsystematic. Every investment is impacted by both types of risk, though the risk composition will vary across securities.
Systematic Risk
The systematic risk of a security or asset type is associated with the overall market. This risk affects every security, and it is unpredictable and undiversifiable. Nevertheless, the systematic risk of a single market/asset type within a portfolio can be somewhat mitigated by building a diversified portfolio of various asset types. However, the systematic risk of a single asset type, market or security itself can’t be mitigated by diversification, it can only be mitigated with an appropriate hedging strategy.
One of the systematic risks that can impact all asset types in a country is the so-called political risk, as for example no investor would be able to exit a country when the respective government puts cross-border currency restrictions in place. Another example of this are sanctions, which may impacted the ability to buy or sell bonds, equities and/or other securities in a given country. Both kinds of restrictions will also impact the local currency, which means even assets that are not impacted by the main event will be impacted by the currency effects.
The systematic risk of a single security or a portfolio compared to the market can be measured with beta. A beta of 1 means that the respective security or portfolio has the same level of risk (volatility) as the market, while a beta below 1 indicates a lower risk and a beta above 1 a higher risk compared to the market.
Unsystematic Risk
The unsystematic risk is the opposite of systematic risk, as it affects only a specific security or sector. This means unsystematic risk can be mitigated through diversification. That said, every security (even an active managed mutual fund) has a different level of unsystematic risk.
There are five different risk areas inside or outside a company that can cause unsystematic risk:
- business risk
- financial risk
- operational risk
- strategic risk
- legal and/or regulatory risk
A typical company-related unsystematic risk can be a strike by the workforce, which could heavily impact the (quarterly) profit of a company, while a new regulation, for example the ban of a specific raw material or product, which affects all companies in an industry/sector, is considered a sector-related unsystematic risk.
This means the total risk of a security or portfolio has two components that need to be taken into consideration, the systematic risk plus the unsystematic risk.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Lipper or LSEG.
