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Chapter 2 — INVESTMENT RISK
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INVESTMENT RISK

INVESTMENT RISK

Investment risk - means that there is a chance that investment's actual gain will be different than expected. This uncertainty includes the possibility of losing some, or even all, of the original investment. Every saving and investment product involves different chances of getting gains and losses. Broadly speaking, investors are exposed to both systematic and unsystematic risks.

INVESTMENT RISK

SYSTEMATIC INVESTMENT RISK

Systematic risk (also known as "un-diversifiable") is a risk that affects every stock in the stock market and cannot be avoided by diversification - investing in different stocks that are not related to one another. The idea of diversification is that when one stock dips, the other stocks in a diverse portfolio will avoid being dragged down with it. It follows the familiar saying: “don’t put all your eggs in one basket.

Systematic investment risk is inherent to the entire market or market segment, and it can affect a large number of assets. It affects the overall market – not just a particular stock or industry. This type of investment risk is both unpredictable and impossible to avoid completely. Examples include interest rate changes, inflation, recessions, and wars.

Here’s an example: say Mike invests $1,000 in Google Inc. About a week later, the stock market plummets 500 points due to a recession (and his investment suffers a loss as a result). Mike’s not too happy about this, and for the next month, the market doesn’t recover. There’s no amount of financial diversification that can overcome this problem – therefore it’s systematic and affects everything.

Notice how the stock market plummeted in 2008. This drop affected every stock out there and no amount of diversification could have alleviated the effect of this drop.

 

Investment risk: systematic risk

To further illustrate the point, here's the same graph showing Ford (NYSE: F) and General Electric (NYSE: GE) alongside the major indexes:

Investment risk: systematic risk

 

UNSYSTEMATIC INVESTMENT RISK

Unsystematic risk - that one, that affects a very small number of assets.  Also known as "diversifiable", specific, diversifiable risk and residual risk, this type of risk refers to the uncertainty inherent in a company or industry investment. Examples include a change in management, a product recall, a regulatory change that could drive down company sales and a new competitor in the marketplace with the potential to take away market share from a company in which you’re invested. In contrast to systematic risk, unsystematic investment risk is the company or industry specific risk that is inherent in each investment. This type of risk can be alleviated through diversification.

Using our previous example, let’s take Mike’s $1,000 investment in Google, Inc. The day after investing his money in the company, he reads in the daily newspaper that the current CEO of Google resigns! This concerns investors because that particular CEO is the person who made Google successful and now he’s gone! As a result, his investment plummets. Although this is bad for Mike’s investment in Google, his other investments shouldn’t be affected.

 

 

Alex's thoughts: 
A risk is something that stops other people to do what the risktaker is doing. Some of the best investments are made when someone goes where no one has gone before.

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