Any investment you make in life will, for the most part, have some risk attached to it.
Other than guaranteed returns from savings accounts and the like, traders know that every time they open a position in a market, they are welcoming risk of some kind.
There are, broadly speaking, two different types of risk associated with investing: systematic and unsystematic. Essentially, there are elements of risk that we can do something about, and there is that market ‘peril’ that, ultimately, is beyond our control.
Differences Between Systematic and Unsystematic Risk
To get started, it makes sense to understand the different types of risk that can impact upon a trader.
Systematic risk is that which is market-bound, and can be caused by an array of political, economic or sociological factors. These are issues beyond your control that will, typically, adversely affect the value of your investments – the coronavirus pandemic has been a systematic risk to investment. Only those who diversified into precious metals or safe-haven currencies – or the growth stocks that emerged in 2020 – would have come through unscathed.
Unsystematic risk is that which comes when investing in a particular company, currency pair or asset. This can come via a change in management, regulatory changes, an impacted supply chain, poor trade links, bad press, weak earnings reports, and all of those other things that can hit a business or a country’s currency value.
As you can see, systematic risk is beyond your control and there’s not a great deal you can do about it. But unsystematic risk? Well, that is yours to own and cut out completely if you wish to be a successful investor in the long term.
Types of Unsystematic Risk
Understanding the different types of unsystematic risk offers a greater insight into the dangers that exist when trading from unforeseen circumstances.
When buying stocks, you should do your research into a business’s quantitative performance – its profitability, net revenue, earnings, and so on.
However, you may not uncover those organizational failings that can enhance unsystematic risk. This could be a loss of market share due to decision-making errors; it could be a chink in the supply chain; or it could be a complete stop in production.
Whatever the cause, operational risk can affect your investments on a short or medium-term basis.
Debt, credit, equity, cash flow – all of these things feed into the financial health of a company.
Risk mounts when the negative aspects of a business’s finances outweigh the positives, so it makes sense to do your research into a firm’s position before making your investment.
An unexpected change in the law can bring a company to its knees or, at the very least, erode a competitive advantage it may previously have had.
There may also be increased operational costs or even legal challenges to come, and some regulatory changes have even forced some firms out of business in the past.
Tips for Reducing Unsystematic Risk
How can we minimize our exposure to unsystematic risk?
In truth, there are many unforeseen variables that ultimately prevent any trade from being ‘perfect’ – things can happen, on a micro and macro scale, that can quickly remove any profit you may have enjoyed on an open position.
We, therefore, need to think deeply about the trades we make and the positions we want to open, and consider ways that we can minimize our exposure to unsystematic risk as much as possible.
Use the Data
When you trade via an online broker, you will have access to a software package that will have a range of technical tools and charts built in.
You should use these to ensure that, day to day, you are in the best place to identify unsystematic risk being displayed in the market. As soon as the signs reveal themselves, you can close your position.
There are lots of different brokers out there, so make sure that you read Tradeo reviews and those for other brands to get your foundation in place.
One of the easiest ways to minimize unsystematic risk is to diversify your portfolio in a number of different areas.
If you pump 100% of your investment capital into a single asset, and that asset fails, then your money will be gone – that’s a no-brainer.
By hedging your bets and diversifying your holdings, you spread your risk – lowering the chance of a destructive event wiping out your bankroll.