Types of Investment Risk
Risk is the amount an asset deviates from its’ expected value and the probability of that deviation. Total risk is made up of two types of risk; systematic risk and unsystematic risk. If risk can be described in one word, it would be volatility.
Systematic Risk
Systematic risk is the risk associated with market returns. This is the risk to the value of an investment portfolio that cannot be attributed to the specific risk of individual investments. Sources of systematic risk would be macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, wars, etc. that affect the whole market.
Asset allocation can partially mitigate systematic risk. By owning different asset classes with low correlation a portfolio manager can smooth portfolio volatility (risk) because asset classes act differently to macroeconomic factors. When some asset categories are increasing others may by falling and vice versa.
Unsystematic Risk
Unsystematic risk is industry or company specific risk. This is risk specific to the individual investment or small group of investments and is uncorrelated with stock market returns. Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk.
Diversification can nearly eliminate unsystematic risk. If an investor owns just one stock and something negative happens specific to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 50, or 100 stocks 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.
Probability and Expected Value
The expected value or return of a portfolio is the sum of all the possible returns multiplied by the probability of each possible return. Risk is the amount of deviation and the probability of that deviation from the expected return. By addressing systematic risk with asset allocation and unsystematic risk with diversification a portfolio manager can reduce the total risk of the portfolio.
The combination of asset allocation and proper diversification reduces both types of risk (systematic and unsystematic) and allows a portfolio manager to put higher risk/higher reward assets in the portfolio without accepting additional risk. This is called portfolio optimization. In other words, if a manager is willing to take a given amount of risk, through asset allocation and diversification total risk is reduced, therefore more aggressive investments can be added to the portfolio and still maintain the given amount of risk the manager is willing to accept. Risk management strategies such as asset allocation and diversification are foundations of sound investment management.
Related Reading: Risk Management
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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hi,ken
You give very Good information about type of investment Risk But on Live trade monitoring and investment risk management is important as our intraday strategy uses leverage to amplify small market movements to generate returns. But leverage is symmetric and amplifies losses too, so risk management is critical for capital preservation
Day trading is not investing but gambling. Get rich schemes only bring wealth destruction to the majority of investors because they don’t have the expertise to gamble. The people who make the money are the brokers who make fees and commission.
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