Types of Investment Risk Risk is the amount an asset deviates from its expected value and the probability

of that deviation. Total risk is made up of two types of risk; systematic risk and unsystematic risk. If risk can be described in one word, it would be volatility. Systematic Risk Systematic risk is the risk associated with market returns. This is the risk to the value of an investment portfolio that cannot be attributed to the specific risk of individual investments. Sources of systematic risk would be macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, wars, etc. that affect the whole market. Asset allocation can partially mitigate systematic risk. By owning different asset classes with low correlation a portfolio manager can smooth portfolio volatility (risk) because asset classes act differently to macroeconomic factors. When some asset categories are increasing others may by falling and vice versa. Unsystematic Risk Unsystematic risk is company specific or industry specific risk. This is risk specific to the individual investment or small group of investments and is uncorrelated with stock market returns. Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk. Diversification can nearly eliminate unsystematic risk. If an investor owns just one stock and something negative happens specific to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 50, or 100 stocks the damage done to the portfolio is minimized. The important concept of unsystematic risk is that it is not correlated to market risk and can be nearly eliminated by diversification. Probability and Expected Value The expected value or return of a portfolio is the sum of all the possible returns multiplied by the probability of each possible return. Risk is the amount of deviation and the probability of that deviation from the expected return. By addressing systematic risk with asset allocation and unsystematic risk with diversification a portfolio manager can reduce the total risk of the portfolio.

The combination of asset allocation and proper diversification reduces both types of risk (systematic and unsystematic) and allows a portfolio manager to put higher risk/higher reward assets in the portfolio without accepting additional risk. This is called portfolio optimization. In other words, if a manager is willing to take a given amount of risk, through asset allocation and diversification total risk is reduced, therefore more aggressive investments can be added to the portfolio and still maintain the given amount of risk the manager is willing to accept. Risk management strategies such as asset allocation and diversification are foundations of sound investment management.