There are always risks in the business world. Understanding these risks enables us to seek more effective approaches to mitigating them. What are these risks and how can they be categorized?
There are two main components of risk: systemic and unsystematic. Let’s explore each risk and learn the best way to mitigate it.
Systemic risk, also known as “market risk” or “non-diversifying risk”, is the result of external and uncontrollable variables, which are not industry or security specific. Inevitably, it affects the entire market leading to price fluctuations of all securities. Risk can be attributed to a number of broad economic factors such as inflation, changes in interest rates, currency fluctuations, recessions, etc.
Since systemic risks cannot be controlled, investors can avoid them by staying away from all risky investments.
Financial Planning – Systematic Risk Mitigation
Systematic risks can be mitigated by certain course of action. How can they be mitigated?
Asset allocation may partially mitigate systemic risks. Possession of different categories of assets (eg bonds, cash, commodities, etc.) with low or zero correlation helps because they arrive differently from macroeconomic factors; some asset categories may rise and others may fall.
Asset allocation should also be adjusted according to estimates. Investments that have been overvalued should be avoided or owned less. When systemic risks are mitigated within a diversified portfolio, cash may be the most important and undervalued asset category.
Another way to reduce systemic risk is through protection. Investors can take advantage of opportunities such as buying safeguards for their securities. A hedge is the risk management strategy that investors use to hedge the loss of unrealized gains. The value of the securities will increase if the value of the securities falls. However, the options are for a fixed period of time and once they expire, investors must buy new ones to stay safe.
In contrast, unsystematic risk refers to risk factors that are specific to a company, industry and sector, and can be controlled to a certain degree. These factors include the management of a company, financial practices, financial health and its competitive position in the market.
Financial Planning – Unsystematic Risk Mitigation
Unsystematic risk can be reduced by diversifying. To achieve this, the investor can diversify his product portfolio, so that revenue does not depend on just a few products. Much risk is reduced when an investor’s risk spreads between different industries (such as banks or healthcare) and asset classes. For example, if an investor owns a diversified portfolio with more than 10 individual investments compared to just one, the damage done to their portfolio is minimized when something negative happens to some of the companies.
Again, unsystematic risk can be almost eliminated by diversification as it is not related to market risk.
Both systematic and non-systemic risks are part of the business parcel. Through risk management solutions as mentioned above, these risks can be partially mitigated, and investors will be able to see an increase in portfolio returns and optimization in the investment portfolio.