There are always risks in the business world. Understanding these risks enables us to seek the most effective ways to mitigate them. What are these risks and how can they be categorized?
There are two main components of risk: systematic and non-systematic. Let’s explore each risk and learn how best to mitigate them.
Systematic risk, also known as “market risk” or “non-diversifiable risk”, is the result of external and uncontrollable variables, which are not industry or security specific. Generally unavoidable, it affects the whole market leading to a fluctuation in the prices of all securities. The risk can be attributed to a number of broad economic factors such as inflation, interest rate changes, currency fluctuations, recessions, etc.
Since systematic risks cannot be managed, investors can avoid them by staying away from all risky investments.
Financial Planning – Systematic Risk Mitigation
Systematic risks can be mitigated with some actions. How can they be mitigated?
Asset allocation can partially mitigate systematic risks. Owning different asset categories (i.e. bonds, cash, commodities, etc.) with low or zero correlation helps because they arrive differently from macroeconomic factors; some asset categories may increase and others may decrease.
Asset allocation should also be adjusted at valuations. Overcrowded investments should be avoided or owned. In mitigating systematic risks within a diversified portfolio, cash may be the most important and undervalued asset category.
Another way to systematically reduce risk is through hedges. Investors can use options such as buying protective gadgets on their securities. A risk management strategy is a protective approach that investors use to protect against the loss of unrealized gains. Giving value will rise if the value of securities goes down. However, the options are time-limited and once expired, investors need to buy new ones to stay hedged.
In contrast, unsystematic risk refers to risk factors that are specific to a company, industry and sector, and which can be controlled to some extent. These factors include company management, financial practices, financial health, and its competitive position in the market.
Financial Planning – Non-Systematic Risk Mitigation
Non-systemic risk can be reduced by diversification. To achieve this, the investor can diversify its product portfolio so that revenues are not solely dependent on a few products. Much risk is reduced when investor risk is spread among different industries (such as banking or healthcare) and asset classes. For example, if an investor owns a diversified portfolio of more than 10 individual investments rather than just one, the damage done to his portfolio is reduced when something negative happens to some of the companies .
Again, non-systematic risk can be eliminated by diversification as it is not linked to market risk.
Systematic and non-systemic risks are integral to businesses. 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.