In this article, we will explore in detail about what is systematic risk and what is unsystematic risk, the differences between systematic and unsystematic risk and provide proper explanations regarding how to mitigate unsystematic risk with practical examples, and effective strategies to mitigate unsystematic risk. Each strategy will be explained with simple examples to demonstrate how they work in real-world scenarios.
In finance, risks are generally categorized as systematic and unsystematic risk. Understanding the difference between them is essential for effective investment management and portfolio diversification. Here’s a breakdown of each:
1. Systematic Risk
What is systematic risk?
Also known as market risk or non-diversifiable risk, systematic risk affects the entire market or a large segment of it. This type of risk is inherent to the entire market and cannot be eliminated through diversification. It includes factors that impact all securities to some extent.
Examples of Systematic Risk:
- Economic Changes: Economic downturns, recessions, and inflation can affect the overall market.
- Interest Rates: Changes in interest rates by central banks can impact stocks, bonds, and other assets.
- Political Events: Elections, trade wars, and regulations can cause market-wide fluctuations.
- Natural Disasters: Major events like pandemics or climate-related disasters can impact global markets.
Systematic risk is often measured by a security’s beta, which reflects its volatility relative to the market.
2. Unsystematic Risk
Also known as specific risk, idiosyncratic risk, or diversifiable risk, unsystematic risk is associated with individual companies or sectors. It arises from factors specific to a particular company or industry and can be mitigated through diversification (spreading investments across multiple assets or sectors).
Examples of Unsystematic Risk:
- Company Performance: Poor management decisions, product recalls, or financial scandals can affect a company’s stock.
- Industry-Specific Risks: Certain industries face unique risks, such as regulatory changes for the healthcare sector or fluctuating commodity prices for energy companies.
Operational Risk: Issues like supply chain disruptions, labor strikes, or technology failures affect specific companies or industries.
Key Differences between Systematic and Unsystematic Risk
| Feature | Systematic Risk | Unsystematic Risk |
| Scope | Affects entire market | Specific to a company or sector |
| Diversification Impact | This cannot be mitigated through diversification | This can be mitigated with diversification |
| Examples | Inflation, interest rate changes, political instability | Company performance, sector risks |
As you now know the basic knowledge regarding systematic and unsystematic risk, now let’s learn how can we minimize the unsystematic risk.
How to Mitigate Unsystematic Risk in Your Investment Portfolio
Before we dive into strategies, let’s quickly recap what unsystematic risk is. Unsystematic risk, sometimes called specific risk, is the risk associated with a particular company or industry. Unlike market-wide risks that affect everyone, like economic recessions or inflation (known as systematic risks), unsystematic risks can usually be reduced by diversifying your investments. For example, if a specific company faces a scandal, its stock might drop, but this won’t necessarily affect other stocks in your portfolio.
Here’s a breakdown of the methods how to minimize unsystematic risk in simple terms with examples for each:
1. Diversify Across Different Stocks
One of the easiest and most effective ways to reduce unsystematic risk is to diversify your stock investments. Instead of putting all your money into one stock, spread it out across several companies. This way, if one company’s stock underperforms, it won’t drag down your entire portfolio.
Example: If you love Apple and decide to invest heavily in it, that’s fine—but also consider adding a few shares of companies from other industries, like Walmart or Pfizer. This way, if Apple struggles, you still have other stocks that may perform well, balancing your overall returns
2. Diversify Across Different Sectors
Diversifying across companies is a great start, but it’s also important to think about sectors, or industries. Sectors include technology, healthcare, finance, energy, and more. Different sectors have unique risks. By investing in various sectors, you’re protecting yourself from industry-specific problems.
Example: If you have investments in several tech companies, try expanding into other sectors. For instance, buy shares in companies from the healthcare sector, like Pfizer, or the retail sector, like Procter & Gamble. If something happens to the tech sector as a whole (like regulatory changes), your investments in other sectors will help balance your portfolio.
3. Invest in Mutual Funds or Exchange-Traded Funds (ETFs)
Mutual funds and ETFs are investment products that include a bundle of stocks, bonds, or other assets. By investing in a single fund, you’re instantly diversifying, as each fund typically holds shares in many companies.
Example: Let’s say you want exposure to the technology sector but don’t want to choose individual tech stocks. You could buy a tech-focused ETF, which might include Apple, Google, Microsoft, and more. If one tech stock doesn’t perform well, the impact on the ETF is smaller since it’s spread across multiple companies.
4. Geographical Diversification
Investing in companies from different countries or regions can help protect your portfolio from country-specific issues, such as economic downturns, political changes, or natural disasters.
Example: If your portfolio consists mainly of U.S. companies, you’re exposed to any economic changes in the U.S. To reduce this risk, consider investing in some European or Asian companies, or buy an international ETF, which gives you exposure to companies from different parts of the world.
5. Include Bonds or Fixed-Income Securities
Bonds and other fixed-income securities are generally safer investments compared to stocks. Adding some bonds to your portfolio can provide stability and help offset any losses from stocks, as bonds are usually less affected by company-specific issues.
Example: Suppose you have a portfolio that’s 100% in stocks. By shifting 20-30% of your portfolio into bonds, you’re balancing the risk. If the stock market takes a hit, your bond investments are likely to be less affected, keeping your portfolio more stable overall.
6. Invest in Low-Correlation Assets
Low-correlation assets are investments that don’t move in the same direction as stocks. This means that when stocks go down, these assets might not follow the same pattern, helping balance out your portfolio.
Example: Real estate, gold, and commodities are commonly used low-correlation assets. If you add these to your portfolio, you’re less likely to see your entire portfolio drop if the stock market declines.
7. Limit Exposure to High-Risk Investments
While high-risk investments can offer big rewards, they’re also more volatile. By limiting the portion of your portfolio to high-risk assets, you reduce the potential for significant losses.
Example: Let’s say you’re interested in a high-risk investment like cryptocurrency. Instead of investing 50% of your portfolio in it, you might decide to invest only 5%. This way, if it loses value, the effect on your entire portfolio is minimized.
8. Regular Portfolio Rebalancing
Over time, some investments will grow faster than others, changing the balance of your portfolio. Regular rebalancing ensures that your portfolio stays aligned with your original risk tolerance and goals.
Example: Suppose your initial plan was to keep 60% in stocks and 40% in bonds. If your stocks perform really well, you may end up with a portfolio that’s now 70% stocks and 30% bonds. By selling some of the stocks and buying more bonds, you’ll return your portfolio to the 60-40 balance, which is more in line with your original risk level.
9. Avoid Over-Concentration in Employer’s Stock
If you work for a company that offers stock options or stock purchases, it’s easy to accumulate a lot of shares in that company. While it’s great to believe in your employer, it’s also risky to have a large portion of your portfolio tied to your job.
Example: If you work for a company like Tesla and have acquired many Tesla shares, try to sell some and invest in other companies. This way, if something happens to Tesla, both your job and your investments won’t be at risk simultaneously.
10. Hedge with Derivatives (For Advanced Investors)
Hedging with derivatives like options or futures is a more advanced way to protect against potential losses. Derivatives act as an insurance policy on your investments, helping limit losses if a particular asset declines.
Example: Suppose you hold a lot of shares in a particular stock. You could buy a put option, which allows you to sell the stock at a certain price. If the stock’s value drops below that price, the put option gives you a way to sell and protect yourself from further losses.
Wrapping Up
Managing unsystematic risk and learning how to mitigate unsystematic risk is all about balancing your portfolio so that you’re not overly reliant on any single company, sector, or country. By diversifying and using the strategies we’ve outlined, you can make your portfolio more resilient and reduce the impact of unexpected events. Even if you’re new to investing, taking small steps toward diversification can go a long way in protecting your investments.
The key takeaway? Don’t put all your eggs in one basket! Diversifying your investments across different companies, sectors, and asset types is one of the best ways to manage risk effectively.