When investing in the stock market you take on the risk of losing money. There is no way around it. But not all risk is made equally and today we are going to talk about the two types of risks you will encounter when investing and why it matters to you.
When investing, risk boils down to the following- the uncertainty that your investment will not generate the returns you expect it to generate. The uncertainty is the risk. In light of this, any prudent investor will ask the question, ok how do I minimize the uncertainty I won’t earn the return I expect? The answer comes down to the two types of risk found in investing- Systematic and unsystematic risk. Let’s take a look at each.
Systematic risk is the type of risk that is inherent to the stock market. In other words, there is no way around it. If you’re invested in the market, you bear systematic risk. A few examples of systematic risk include:
- The risk that inflation will erode the purchasing power of your bond investments, also known as purchasing power risk.
- The risk that the overall market takes a downturn, resulting in otherwise strong companies also taking a downturn. This is known as market risk.
- The risk that rising interest rates will cause bond prices to fall. Known as Interest Rate risk.
These are all examples of risks that effect every participant of the stock market. In other words, it is “systemic” to the market as a whole.
The other type of investment risk is what is known as “un-systematic risk.” Un-systematic risk is risk that is specific to a particular stock or company. A few examples of un-systematic risk include:
- The risk that a company’s demand for their product falls because of the development of a new and better alternative. Think Blackberry when the iPhone came out. This is what is called business risk.
- The risk that a company’s debt is too great to continue operating. This is known as financial risk.
These types of risks are particular to single companies and not the market as a whole. In other words, they are “un-systematic.”
So why is this important to you as an investor? Well, when you invest your 401k, IRA, or Brokerage account you have now taken on, knowingly or not, both systematic and unsystematic risk. Why this matters is because research has shown that by investing in just fifteen different companies across different industries, you can come close to eliminating one of these risks.
Any guesses as to which one? To review, if Systematic risk is inherit to all participants in the stock market and is unavoidable, this means we can negate un-systematic risk from your portfolio by investing in multiple different companies in different industries. This is the essence of diversification and why advisors the country over advise their clients to invest across different sectors, industries, and countries.
Are you unsure your investments are diverse enough or need help diversifying in general? I’m here to help and offer a complimentary second opinion on your investments which you can schedule below!
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