by Kevin Thalersmith

Created on: March 03, 2010   Last Updated: March 04, 2010

The recent upheaval in the world markets has made investors reconsider risk and how it effects their investments.  One misguided idea is risk is a bad thing for investors.  But that simply isn’t true; risk is the way investors make money.  They receive returns in exchange for taking risk others won’t.  But if these risks are contained, investors will lose a lot of money.  Two risks investors need to understand are unsystematic risk and systematic risk.

Unsystematic Risk

Unsystematic risk refers to a risk that doesn’t involve the whole financial system but is restricted to an individual stock or sector.  This could be anything from the chance of a company’s founder or CEO being fired to a collapse in metal prices hurting the earnings of mining companies.  Many of the risks involving individual companies come rather suddenly and are impossible to predict.  Every investor in companies must realize their stock’s price will fall if they release bad earnings.  Same applies to revelations of fraud or misstated earnings.  Bankruptcy, no matter how low the risk, is another risk that investors must keep in mind when involving companies.  Many people don’t know a large portion of a stock’s value is derived from its sector.  When investing in an individual stock, keep in mind the stock’s sector.  The risk of a sector, from the price of raw materials to wide decreased earnings, must be considered for every investment.

How to lower unsystematic risk

One of the ways to lower the unsystematic risk of a whole portfolio is to use diversification.  This means buying stocks from many different sectors so the stocks don’t trend with each other.  In general, when some sectors or industries are making money, others will be losing money.  The ups and downs of a portfolio’s value are balanced out with diversification.  However, there are many downsides to diversification.  This method can lower the total returns of a portfolio by having both losses and gains which may balance each other out.  Diversification also doesn’t protect against systematic risk, the second type of risk.

Systematic Risk

Systematic risk refers to risk that effects the whole financial system.  These black swan events can cause panic across investment markets and start off a recession.  The most recent one happened in the credit crisis of 2007-2008,

• 1
• 2
• Next Page >>