Risk Associated with Investments

What is Risk?

In finance, risk is the probability that actual results will differ from expected results. In
the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept
of “risk and return” is that riskier assets should have higher expected returns to compensate
investors for the higher volatility and increased risk.

The risk is the degree of uncertainty in any stage of life. For instance, while crossing the road,
there is always a risk of getting hit by a vehicle if precautionary measures are not undertaken.
Similarly, in the area of investment and finance, various risks exist since the hard-earned money
of individuals and firms are involved in the cycle.

In this article, we shall be focussing on the differences between Systematic and Unsystematic
Risk. These risks are inevitable in any financial decision, and accordingly, one should be
equipped to handle them in case they occur.

Systematic Risk does not have a specific definition but is an inherent risk existing in the
stock market. These risks are applicable to all the sectors but can be controlled. If there is
an announcement or event which impacts the entire stock market, a consistent reaction
will flow in which is a systematic risk. E.g., if Government Bonds is offering a yield of
5% in comparison to the stock market, which offers a minimum return of 10%. Suddenly,
the government announces an additional tax burden of 1% on stock market transactions;
this will be a systematic risk impacting all the stocks and may make the Government
bonds more attractive.

Systematic Risk Example

For example, inflation and interest rate changes affect the entire market. So, one can
only avoid it by not investing in any risky assets. More examples of systematic risk are
changes to laws, tax reforms, interest rate hikes, natural disasters, political instability,
foreign policy changes, currency value changes, failure of banks, economic recessions.
 Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is
also known as “Specific Risk,” “Diversifiable risk,” or “Residual Risk.” These are risks
which are existing but are unplanned and can occur at any point in causing widespread
disruption. E.g., if the staff of the airline industry goes on an indefinite strike, then this
will cause risk to the shares of the airline industry and fall in the prices of the stock
impacting this industry.

One should keep in mind the below formula, which in a nutshell highlights the
importance of these 2 types of risks faced by all kinds of investors:

The above risks cannot be avoided, but the impact can be limited with the help of
diversification of shares into different sectors for balancing the negative effects.

Difference between Systematic and Unsystematic Risk

To get a more thorough understanding, we need to understand the difference between

systematic and unsystematic risk. Unsystematic or “Specific Risk” or “Diversifiable
Risk” or “Residual Risk” are primarily the industry or firm-specific risks that are there in
every investment. Such risks are also unpredictable and can occur at any time. Lik e, if
workers of a manufacturing company go on a strike resulting in the drop in the stock
price of that company.

Following are the differences between the two:

Unsystematic risk is related to the specific industry, segment or security, while the
Systematic risk is the loss associated with the entire market or the segment.

Unsystematic risk is due to the internal factors, and hence, can be controlled or
reduced. Systematic risk, on the other hand, is uncontrollable.

Unsystematic risk affects the stock of a specific company, while systematic risks
impact almost all securities in the market.
 We can remove unsystematic risk using diversification. However one can control
systematic risks by using only methods like hedging and asset allocation.

Does Diversification Eliminate Risk?

The risk associated with the portfolio is lower or negligible if it’s diversified. It is
because any loss in one asset is likely to be offset by a gain in another asset (which is
negatively correlated).

Systematic risk refers to the risk that is common to the entire market, unlike idiosyncratic
risk, which is specific to each asset. Diversification cannot lower systematic risk because
all assets carry this risk.

Portfolios can be diversified in a multitude of ways. Assets can be from different industries,
different asset classes, different markets (i.e., countries), and of different risk levels. The key to a
diversified portfolio is holding assets that are not perfectly positively correlated.