Investments have two components that create risk. Risks specific to a
particular type of investment, company, or business are known as
unsystematic risks. Unsystematic risks can be managed through
portfolio diversification, which consists of making investments in a
variety of companies and industries. Diversification reduces
unsystematic risks because the prices of individual securities do not
move exactly together. Increases in value and decreases in value of
different securities tend to cancel one another out, reducing
volatility. Because unsystematic risk can be eliminated by use of a
diversified portfolio, investors are not compensated for this risk.
Systematic risks, also known as market risk, exist because there are
systemic risks within the economy that affect all businesses. These
risks cause stocks to tend to move together, which is why investors
are exposed to them no matter how many different companies they own.
Investors who are unwilling to accept systematic risks have two
options. First, they can opt for a risk-free investment, but they
will receive a lower level of return. Higher returns are available to
investors who are willing to assume systematic risk. However, they
must ensure that they are being adequately compensated for this risk.
The Capital Asset Pricing Model theory formalizes this by stating that
companies desire their projects to have rates of return that exceed
the risk-free rate to compensate them for systematic risks and that
companies desire larger returns when systematic risks are greater.
The other alternative is to hedge against systematic risk by paying
another entity to assume that risk. A perfect hedge can reduce risk
to nothing except for the costs of the hedge.
I have provided a number of sources that will assist you in furthering
your understanding of systematic and unsystematic risks, the
relationship of risk and return, and how to avoid systematic or market
"Principles of Corporate Finance" Fourth Edition by Brealey & Myers,
McGraw-Hill Inc. (1991) pages 137-139 and 916.
"Session 9: Capital Asset Pricing Model (CAPM)" The Malawi College of
"Hedge" Investopedia.com (2006) http://www.investopedia.com/terms/h/hedge.asp
"Systematic Risk" Investopedia.com (2006)
"Unsystematic Risk" Investopedia.com (2006)
"Capital Asset Pricing Model" Wikipedia (May 30, 2006)
"Systemic Risk" Wikipedia (April 21, 2006)
"The risk and return relationship part 1: portfolio theory" by Patrick
Lynch (April 28, 2004)
"The risk and return relationship part 2: CAPM" by Patrick Lynch
(April 29, 2004) http://www.accaglobal.com/publications/studentaccountant/1144332
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