Unsystematic risks are considered governable by the company or industry.Diversification can nearly eliminate unsystematic risk. If an investor owns just one stock or bond and something negative happens to that company the investor suffers great harm. In stock markets we divide risk into systematic risk and unsystematic risk. Unsystematic risk is unique to assets or sectors or themes and can be reduced by diversifying to other asset classes. When we talk of risk reduction through diversification, we always talk of unsystematic risk; and that is why it is also called diversifiable risk.
It is commonly advised to diversify by investing in a range of industries or sectors to prevent this. Second-level filters for identifying stocks based on lower debt to equity ratio, positive operating cash flow over past cycles to essentially build downside protection in our portfolios. We supplement this by looking at various other parameters like PEG ratio enrolled agent meaning (Price/Earnings to Growth), which show us that we are mindful of how much we are paying today for future growth potential. A recent example of our processes has been to successfully avoid large drawdowns due to our non-participation in some of new age tech company IPOs. Our investment filter on positive cash flows worked in our favour in this case.
Assessing Risk & Opportunities
That said, a depreciating rupee makes Indian products and services more attractive globally, thereby benefiting the export sector. Meanwhile, an appreciating rupee has the opposite impact, providing benefits to imports but hurting exports in the process. This systematic risk includes such https://1investing.in/ occurrences as inflation, war and fluctuating interest rates- generally, those events that influence the entire economy. Of course, diversification cannot eliminate the likelihood of these events happening. Systematic risk accounts for most of the risk in a diversified portfolio.
Exchange rate risk arises due to fluctuations in the value of the currency of one country vis-à-vis others. In the context of India, this refers to volatility in the value of the rupee against the dollar . Currency risk affects an economy in various ways, depending on whether the home currency is appreciating or depreciating against the foreign currency. A depreciating rupee (which means an appreciating USD/INR) makes imports of goods and services more expensive to Indians as they will have to shell out more rupees for every dollar that they buy. Furthermore, a lot of commodities, such as crude oil and metals, are imported from overseas and tend to be relatively demand inelastic. Hence, a steady depreciation of the rupee raises the import bill and can stoke inflationary pressures if the impact of higher commodity prices costs is passed on to end consumers.
Does diversification help me to remove all kinds of risk in my investment portfolio?
One way to categorize risk is to distinguish between unsystematic risk and systematic risk. If you are investing in debt or equity through mutual funds, you can choose a mutual fund category depending on your risk appetite and time horizon. The first thing to understand is that there is nothing like riskless investing. Even after diversification, there is some element of risk that still remains in your portfolio. However, to buttress this point better, let us understand the two specific kinds of risk.
- One way that academic researchers measure investment risk is by looking at stock price volatility.
- Sources of systematic risk could be macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, wars, etc.
- On the other hand, unsystematic risks can be mitigated with better research and investment decisions.
- It is the fluctuations in the market called the volatility which can be avoided as they are industry specific such as strikes in an industry, management problems.
- We shall talk about hedging and diversification across assets later in this module.
On the other hand, a sustained decline in the price of commodities would have an opposite impact. Exchange rates have an impact not only on end consumers but also on corporates, especially those with global exposure. A depreciating rupee hurts Indian companies that tend to be net importers of goods, services, and commodities. This is because if the demand for the goods and services that these companies sell is price sensitive, they may not be able to completely pass on the cost of higher imports to consumers. Similarly, a depreciating rupee benefits Indian companies who are net exporters of goods and services. This is because Indian goods and services become more attractive globally, which potentially helps in driving higher export volumes and subsequently higher revenues.
Unsystematic Risks that Investors Face
Interest rate risk exists when changes in interest rates affect the price of a security. This is a systematic risk because it affects securities across multiple asset classes – bonds, equities, commodities, currencies, mutual funds, ETFs etc. Changes in interest rates affect equities and commodities indirectly. As interest rates climb, there is a tendency for people to spend less and save more.
Similarly, during commodity bear markets, the weight could be reduced to avoid portfolio underperformance. Hence, having commodity stocks can be beneficial during inflationary times. Finally, one could also gain exposure to commodities directly by buying or selling commodity futures and options listed on an exchange, by buying physical commodities , or by buying financial commodities .
A depreciating rupee (i.e., an appreciating USD/INR) reduces the earnings potential of foreign investors in dollar terms, while an appreciating rupee has the opposite impact. It is for this reason that a steadily depreciating rupee tends to increase volatility in the domestic stock and bond markets, and vice versa. Similarly, if an Indian investor intends to invest a certain portion of his/her capital in, say, the US markets, he/she needs to have a view not only on the US markets but also on the USD/INR exchange rate. Once invested, if the dollar appreciates over time, the investor’s earnings in rupee terms would be higher, and vice versa. Hence, exchange rate is a critical factor that needs to be considered when making investments overseas.
What is systematic risk and unsystematic risk?
One commodity that tends to post a significant risk to global stability is crude oil, given its widespread application across sectors. As an example, when the OPEC imposed an embargo on oil exports between October 1973 and March 1974, it caused oil prices in the US to quadruple during this period. This had a catastrophic impact on the US economy – inflation and interest rates surged to double digits, and the economy fell into a recession that lasted until March 1975. Meanwhile, the US stock markets also crashed and experienced a period of lost decade, as it barely offered any noticeable returns until late-1982. Similarly, the oil price crash between 2014 and 2016 had a profound negative impact on oil producing companies and nations whose major exports comprise of crude oil.
- In this case diversification usually means owing long-intermediate and short- term government bonds.
- Systematic Risk comes from the inﬂuence of external factors on an organisation – those which are not under the control of the organisation.
- While these are the overall risks that concern the ﬁnancial markets, you must, at an individual level recognise yours before you start investing.
- Few risks can be reduced by diversification into assets that are not correlated with that particular market.
- Meanwhile, an appreciating rupee has the opposite impact, providing benefits to imports but hurting exports in the process.
The part of risk that can be diversified away is known as unsystematic risk. It is the risk specific to individual securities or a small class of investments. Hence, it can be diversified away by including other assets in the portfolio. Credit risk, business risk, and liquidity risks are unsystematic risks. As enumerated above, our investment processes at PGIM India are set up precisely to mitigate all three types of risk in the portfolio.
Macro factors which influence the direction and volatility of the entire market would be systematic risk. An individual company cannot control systematic risk.Systematic risk can be partially mitigated by asset allocation. Owning different asset classes with low correlation can smooth portfolio returns because asset classes react differently to macroeconomic factors. When some asset categories (i.e. domestic equities, international stocks, bonds, cash, etc.) are increasing others may be falling and vice versa. Finally, exchange rates have an impact on the flows of foreign money into a nation’s stock and bond markets too. This is because foreign investors are impacted not only by movements in stock prices but also by fluctuations in the exchange rate.