i. The concept of systematic risk and how it is related to other types of risk such as common risk, idiosyncratic risk or independent risks.
There is different type of risk in evaluating an investment that are commonly used by decision makers in both private corporations and public agencies. Each of these types when used properly, a manager can increase portfolio returns or reduce risk to optimize an investment portfolio. However, it is important to define these types of risk precisely.
Systematic risk, This type of risk is also called common risk, undiversifiable risk, or market risk. This risk is associated with market returns, which can be attributed to broad factors. It is risk to your investment portfolio that cannot be attributed to the specific risk of individual investments. This risk is perfectly correlated
Fluctuations of a stock’s return that are due to market-wide news represent common
risk. As with earthquakes, all stocks are affected simultaneously by the news. Sources of systematic risk is due to market wide news which could be macroeconomic factors such as changes in interest rates, inflation, fluctuations in currencies, wars, recessions, etc.
Macro factors which influence the direction and volatility of the entire market would be systematic risk. An individual organization cannot control systematic risk. systematic risks are not diversified in a large portfolio and can be partially mitigated by asset allocation. Owning different asset classes with low correlation can smooth portfolio volatility because asset classes react differently to macroeconomic factors. When some asset categories (i.e. domestic equities, international stocks, bonds, cash, etc.) are increasing others may be falling and vice versa.
To further reduce risk, asset allocation investment decisions should be based on valuation. I want to adjust my asset allocation target according to valuations. I want to overweight those asset classes that are bargains and own less or avoid investments which are overpriced. When mitigating systematic risk within a diversified portfolio, cash may be the most important and under appreciated asset category.
Unsystematic risk, This type of risk is also called idiosyncratic risk or independent risk. This is risk attributable or specific to the individual investment or small group of investments. It is uncorrelated with stock market returns. Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk.
Examples of risk that might be specific to individual companies or industries are business risk, financing risk, credit risk, product risk, legal risk, liquidity risk, political risk, operational risk, etc. Unsystematic risks share no correlation and are considered governable by the company or industry.
Unsystematic risks are diversified in a large portfolio. Proper diversification can nearly eliminate unsystematic risk. If an investor owns just one stock or bond and something negative happens to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 30, or 40 individual investments, the damage done to the portfolio is minimized.
The important concept of unsystematic risk is that it is not correlated to market risk and can be nearly eliminated by diversification.
Symetric Risk or Common risk Unsymetric Risk or Independent Risk
Its Undiversifiable Its diversifiable
Caused due to markrt wide news Caused due to specific news
Not diversifiable in large portofolios Its diversifiable in large portofolios
Its perfectly correlated Its not correlated
Systematic and unsystematic risks can be partially mitigated with risk management solutions such as asset allocation, diversification, and valuation timing. Used properly, a manager can increase portfolio returns and/or reduce risk to optimize an investment portfolio.