Risk in investing comes in two flavors: systematic and unsystematic. Systematic risk affects the entire market and can't be avoided, while unsystematic risk is specific to individual companies or industries and can be reduced through diversification.

Diversification is key to managing risk in your investment portfolio. By spreading your investments across different assets, sectors, and regions, you can minimize the impact of company-specific risks. However, remember that diversification can't protect you from market-wide risks.

Types of Risk and Diversification

Systematic vs unsystematic risk

• Systematic risk (market risk, undiversifiable risk)
  • Affects entire market or economy
  • Cannot be eliminated through diversification
  • Sources:
    • Changes in interest rates (Federal Reserve raising rates)
    • Inflation eroding purchasing power (rising consumer prices)
    • Political events like elections or policy changes (new tax laws)
    • Economic downturns such as recessions (2008 financial crisis)
• Unsystematic risk (specific risk, diversifiable risk)
  • Affects individual companies or industries
  • Can be reduced or eliminated through diversification
  • Sources:
    • Management decisions impacting company performance (poor strategic choices)
    • Labor strikes disrupting production (auto worker walkouts)
    • Product recalls damaging reputation and sales (defective pharmaceuticals)
    • Technological changes making products obsolete (rise of smartphones)

Diversifiable risk elimination

• Diversifiable risk can be reduced or eliminated by investing in variety of assets
• Achieved through portfolio diversification spreading risk across multiple investments
• Involves selecting assets with low or negative correlation (stocks and bonds)
• Aims to balance portfolio's overall risk and return for optimal performance
• Example: Investing in both domestic and international stocks from various sectors

Market risk impact on returns

• Market risk factors are macroeconomic variables affecting asset returns
  • Interest rates influencing borrowing costs and investment attractiveness (10-year Treasury yield)
  • Inflation impacting purchasing power and asset values (Consumer Price Index)
  • GDP growth indicating economic health and corporate profits (quarterly GDP reports)
  • Exchange rates affecting international investments and trade (USD/EUR rate)
• Changes in market risk factors lead to fluctuations in asset prices
  • Positive or negative impact depending on asset and risk factor
  • Systematic risk cannot be eliminated but impact can be managed
  • Example: Rising interest rates negatively impacting bond prices

Diversification for risk reduction

• Diversification strategies:
  1. Investing in different asset classes (stocks, bonds, real estate, commodities)
  2. Investing in various sectors or industries (technology, healthcare, energy)
  3. Investing in different geographical regions (US, Europe, emerging markets)
  4. Investing in assets with low or negative correlation (gold and stocks)
• Diversification can significantly reduce unsystematic risk
  • Spreads risk across multiple assets reducing impact of individual fluctuations
  • Effectiveness depends on level of diversification and asset correlation
  • Example: Owning 30 stocks instead of 1 reduces company-specific risk
• Limitations of diversification
  • Does not eliminate systematic risk affecting entire market
  • Over-diversification may lead to reduced returns (owning too many assets)