Unsystematic risk can be avoided through diversification.
One of the key elements of an investor’s knowledge has to be understanding the difference between systematic risk and unsystematic risk.
Risk is one of the two most significant factors that differentiate one investment product from another, with the other being rate of return. Understanding the different kinds of risk helps an investor make investment decisions, whether the investor is an active participant in the stock market or is a cautious first-timer.
Unsystematic risk, which can also be called specific risk, is risk that applies only to one specific company. Poor performance, product returns or recalls, employee strikes or office calamities are all examples of unsystematic risk.
Unsystematic risk is significant if an investor has a large portion of his portfolio invested in one specific company or industry. The need to balance the effects of unsystematic risk, so that a portfolio is not completely wiped out by a single event, is why advisors usually suggest investors diversify their portfolio.
Diversification prevents a portfolio from suffering too greatly when one company or industry suffers a significant loss of market share or confidence, or some other financial calamity.
Systematic risk is the risk that is inherent in being involved in the stock market at all. It is the effect on a portfolio that comes from whatever affects the stock market as a whole, such as wars, inflation, interest rates, political changes and global economic matters. Those events affect not just a single company or industry but the entire financial world.
Balancing systematic risk is difficult, because no company or industry can avoid the losses that come from major news in the financial or political world. There are ways to hedge the losses that might occur.
For instance, a hedge against an entire economy underperforming is to invest in companies or industries that manage to weather all financial difficulties better than most. Long-standing businesses or essential products and services are examples of investments that will lose less in hard economic times.
Unsystematic risk is avoidable through diversification, and selective diversification is a way to manage the level of systematic risk one’s portfolio might have. But, as they say in almost every prospective ever printed, there is an element of risk in any investment.
Kent McDill is a staff writer for Millionaire Corner. McDill spent 30 years as a sports writer, working for United Press International and the Daily Herald of Arlington Heights, Ill. From 1988-1999, he covered the Chicago Bulls for the Daily Herald, traveling with them every day through the nine-month season. He also covered the Bulls for UPI from 1985-88, and currently covers the team for www.nba.com. He has written two books on the Bulls, including the new title “100 Things Bulls Fans Should Know And Do Before They Die’, published by Triumph Books. In August 2013, his new book “100 Things Bears Fans Should Know And Do Before They Die” gets published.
In 2008, he resigned from the Herald and became a freelance writer. The Herald hired him to write business features and speeches for the Daily Herald Business Conferences and Awards presentations.
McDill also writes a monthly parenting column for the Herald’s Suburban Parent magazine.
McDill is the father of four children, and an active fan of soccer, Jimmy Buffett and all things Disney.