In my previous post, “The Many Faces of Risk”, I mentioned that the market risk can be divided into two: the systematic risk and unsystematic. However, I made clear that both concepts describe them in a future post, in order to not lose track of the main issue was dealing with. But we talk about it now.
Before, it is important to remind all readers the definition of investment risk, which is the variability in the expected return on our investment. To illustrate, let’s look at an example. Investing in the stock market has a higher expected return of 10% per average (at least is what historically has been demonstrated).
But there are years in which the main display (the stock market index) is up 80% and years which can be lowered by 30%. If we maintain our investment in the long run, all these ups and downs will be offset and surely will get the expected performance. But along the way there will be a lot of variability. That is what is defined as a risk.
Of course, every instrument has an associated risk, even those that people perceive as “safe”. In fact sometimes that ‘risks’ ceases to be to become certainty: it is amazing how many people still invest in promissory notes that give a yield 3 percentage points below inflation. One is losing money (purchasing power) to invest there, “safe” way. This will continue talking in the future.
Back to the subject at hand, in modern financial theory, we have identified two main components of risk: systematic risk and unsystematic.
Basically, the systematic risk is what might be called the risk inherent in a market. In other words, it does not affect an action or private sector, but the market as a whole. For example, in a financial crisis or a “stock market crash” all actions tend to fall simultaneously. It is an unpredictable risk but also impossible to completely avoid.
It is said that the systematic risk is not diversifiable risk. But we must clarify that this refers to instruments on the market itself (if one invests only in the stock market then it is indeed a risk no diversifiable).
However, one can invest in different markets and this is also diversification. Thus, systematic risk can be mitigated through an asset allocation strategy (investing in different markets such as stocks and bonds).
On the other hand, many sophisticated investors also control systemic risk through hedging or strategies involving derivative instruments.
By contrast, unsystematic risk is the risk of each individual station, it is he who own and instrument-specific factors. For the stock market, for example, we can say that the unsystematic risk is one that has to do with the discovery of a new product or a new technique that can “take off” a company with a merger, etc.
That is, situations that particularly affect that company and not the rest. In the case of money market, for example, unsystematic risk is one that has to do with the increase or degradation of the rating on the payment capacity of the company issuing the instrument in particular.
Unsystematic risk is said to be diversifiable, because it can reduce or control with proper diversification. For example, in the stock market we can find stocks that have a high correlation with an index, that is, they tend to move similarly, but there are others that have a lower or even negative correlation. Then the combined actions of various kinds can maximize the expected return and reduce risk – diversify intelligently to generate optimal portfolio.