Causes (or Sources) and Types of Risk

A Comprehensive Analysis

Understanding the different types and sources of risk is crucial for effective portfolio management. The core categories provided – Systematic and Unsystematic risk – are fundamental.

1. Systematic Risk (Market Risk / Non-Diversifiable Risk)

• Definition: Risk that affects the entire market or a significant segment of it. It is caused by factors that are largely external to individual companies and cannot be eliminated through diversification. Regardless of how well diversified your portfolio is, it will still be subject to systematic risk.

• Key Characteristics:

  • Non-Diversifiable: Cannot be reduced by adding more assets to the portfolio.
  • External Factors: Arises from macro-economic, political, and regulatory forces.
  • Broad Impact: Affects a wide range of assets and sectors.

• Components of Systematic Risk (as provided):

  • Market Risk:

    • Explanation: Fluctuations in the stock market due to economic events, investor sentiment, and global events.
    • Examples: A recession, a major political event, a global pandemic.

  • Interest Rate Risk:

    • Explanation: Changes in interest rates affecting the value of fixed-income securities (bonds) and the cost of borrowing.
    • Examples: Rising interest rates causing bond prices to decline, impacting bond portfolios and increasing borrowing costs for companies and consumers.

  • Inflation Risk (Purchasing Power Risk):

    • Explanation: Erosion of purchasing power due to rising prices.
    • Examples: Inflation reducing the real return on investments and making it more expensive to maintain a certain standard of living.

  • Exchange Rate Risk (Currency Risk):

    • Explanation: Currency fluctuations affecting the value of international investments.
    • Examples: Changes in exchange rates impacting the returns on foreign stocks or bonds when converted back to the investor's home currency.

  • Political & Regulatory Risk:

    • Explanation: Government policies, regulations, and political instability impacting markets and investments.
    • Examples: Changes in tax laws, trade regulations, or political unrest affecting investor confidence.

• Strategies for Managing Systematic Risk:

  • Asset allocation: Diversifying across asset classes that tend to perform differently in various economic environments.
  • Hedging: Using derivative instruments to offset potential losses from market fluctuations.

2. Unsystematic Risk (Company-Specific Risk / Diversifiable Risk)

• Definition: Risk that affects individual companies or specific industries. It is caused by factors unique to those entities and can be reduced through diversification. This is the risk that any one security increases or reduces overall return.

• Key Characteristics:

  • Diversifiable: Can be reduced by adding more assets to the portfolio, as the negative events impacting one asset are likely to be offset by positive events impacting other assets.
  • Internal Factors: Arises from events within a specific company or industry.
  • Narrow Impact: Affects a limited number of assets or sectors.

• Components of Unsystematic Risk (as provided):

  • Business Risk:

    • Explanation: Risk arising from poor management decisions, increased competition, or changes in consumer preferences.
    • Examples: A company launching a failed product, a competitor introducing a superior product, or a shift in consumer tastes away from a company's products.

  • Financial Risk:

    • Explanation: Risk arising from excessive debt leading to financial instability.
    • Examples: A company taking on too much debt, making it vulnerable to economic downturns or interest rate increases.

  • Operational Risk:

    • Explanation: Risk arising from failures in internal processes, technology, or human error.
    • Examples: A computer system failure disrupting operations, a data breach compromising customer information, or a significant lawsuit.

• Strategies for Managing Unsystematic Risk:

  • Diversification: Investing in a wide range of stocks across different industries and sectors. This is probably the best way to reduce any unsystematic risk.
  • Thorough research: Conducting due diligence on individual companies before investing.

Key Points:

• Total Risk: Total risk = Systematic Risk + Unsystematic Risk
• Diversification is Key: Diversification is a powerful tool for managing unsystematic risk, but it cannot eliminate systematic risk.
• A good wealth manager will make informed decisions with regards to every category above.

In conclusion, a comprehensive understanding of systematic and unsystematic risk is essential for effective portfolio construction. By diversifying across different asset classes, industries, and geographic regions, investors can reduce their exposure to unsystematic risk and create a more resilient portfolio.