There are tons of risks that we take every day without even thinking about them. I drove in a car this morning, and I risked getting into an accident by being on the road with others. After I got to the office I poured myself a cup of coffee and took a sip immediately, being the rebel that I am, and risked burning the inside of my mouth. Now, these are calculated risks because most people drive all over every day and are perfectly fine, and even if I were to burn my mouth on that coffee I know it would heal pretty quickly.
I don’t want to focus on those silly kind of risks, I want to talk about the two major risks that we see from an economic investment standpoint. These risks are systematic risk and unsystematic risk. Otherwise known as market risk and business risk.
A Quick Lesson on Diversification
Diversification, from a financial standpoint, is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. The ultimate goal of diversification is to find a happy medium between risk and return, finding that allocation that lets you achieve what matters while still being able to sleep at night.
Let’s look at unsystematic or business risk first. Business risk refers to the risk of a specific business or businesses within an industry. For example, if hamburger buns grew on trees and that year the supply of the buns was bad, McDonalds would take a hit and it would be reflected in their share price. But this shortage would also effect other companies in the sandwich serving industry that serve things on buns like the always delicious Chik-fil-a. But, for example, the market share of Apple would not be affected because, well, Apple deals in non-tree-grown tech and not buns. Therefore, unsystematic risk can be avoided or decreased, through diversification.
Now systematic risk or market risk refers to the market as a whole. It affects everything all at once whether it's tree-grown buns or Apple tech, it doesn’t matter. It is basically defined as the uncertainty inherent to the entire market. The most recent and powerful example of systematic risk in effect is what went down in 2008 because it was a market-wide event. While tree-grown buns and Apple could have both been affected, they would have been impacted in different ways. However, one would not have been able to mitigate loss through diversification.
How To Remember Which is Which
Trying to keep it simple, the easy way that I used to think about the two is that unsystematic risk doesn’t affect the whole system, just a particular business or industry, and systematic risk affects the whole system - the whole market, no matter what. Diversification is important to protect your assets as a whole, but know that it’s not a fool proof way to not lose money in the case of a market-wide event. Have that conversation with someone who retired in 2008 and ask them how they felt about systematic risk.
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