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  Thursday June 25, 2009

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What Are Unsystematic and Systematic Risks?

All investments are subject to risk. It is generally believed that investors are rewarded for taking risk. However, some risk is not rewarded. Investors need to control or eliminate risks for which they are not rewarded from their investment portfolio. Investment risks can be placed into two broad categories: unsystematic and systematic risks.

Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk could include dramatic events such as a strike, a natural disaster such as a fire, or something as simple as slumping sales. Two common sources of unsystematic risk are business risk and financial risk.

Diversification can greatly reduce unsystematic risk from a portfolio.

Diversification can greatly reduce unsystematic risk from a portfolio. It is unlikely that events such as the ones listed above would happen in every firm at the same time. Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic risk.

On the other hand, some events can affect all firms at the same time. Events such as inflation, war, and fluctuating interest rates influence the entire economy, not just a specific firm or industry.

Diversification cannot eliminate the risk of facing these events. Therefore, it is considered un-diversifiable risk. This type of risk accounts for most of the risk in a well-diversified portfolio. It is called systematic risk or market risk. However, the expected returns on their investments can reward investors for enduring systematic risks.

Investors are induced to take risks for potentially higher returns. However, not all risks offer such potential rewards. The wise investor identifies these risks and eliminates them from his or her portfolio through diversification.

The purchase of a potentially appreciable asset such as a stock, a bond, a property, or a unit of production. The purchase provides funds for the growth of businesses and governments.
The chance of loss due to the uncertainty of future events. Risks can be in political systems, unforeseen changes in management, investor emotions, etc. Uncertainties in exchange rates, interest rates, inflation, loss of principal, etc. are also considered risk.
The total investments of an individual or company.
The risk that underlying assets will default, depreciate, or lose purchasing power over time.
The likelihood that the value of an asset will decline due to circumstances particular to that specific asset and not to the market in general.
The risk that a company will not have adequate cash flow to meet its various operating expenses, including pension and retiree healthcare benefits.
The likelihood that an investment asset will fail or succeed based upon the underlying company's management ability and financial strength.
Spreading investments among different companies, perhaps in different fields. The aim is usually to minimize risk. Diversification also refers to spreading total portfolio assets among multiple classes of investments, such as stocks, bonds, and money market instruments.
1. A person or group that carries on business. It may be in the form of a business or partnership. 2. In securities, firm describes a commitment to buy or sell at a specified price.
A rise in the general price level of goods and services; inflation is the opposite of deflation. The Consumer Price Index and the Producer Price Index are the most common measures of inflation. As a probable result of inflation, labor asks for higher wages to buy more, prices rise to meet those wages, and inflation becomes a cycle.
A percentage that indicates what borrowed money will cost or savings will earn. An interest rate equals interest earned or charged per year divided by the principal amount, and expressed as a percentage. In the simplest example, a 5% interest rate means that it will cost $5 to borrow $100 for a year, or a person will earn $5 for keeping $100 in a savings account for a year.
The likelihood that all investments of a certain type will be adversely affected by an event or market condition.
The likelihood that the value of a particular investment will be worth less on a particular date than the amount for which it was purchased.
Estimated investment results based upon technical analysis of an investment asset.
The earnings on securities or other investments, whether they are dividends or interest, realization of profits or receipts, income, or some other source.
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