What is risk and it’s types? Difference between systematic and unsystematic risks.

Have you ever found yourself in a situation in which you felt like you were dangerously balanced on a tightrope? That’s somehow the way dealing with risk feels! In basic words, risk is the possibility of something unpleasant occurring, particularly in the case of making decisions. It is a part of living, no matter whether you are investing money, creating a new company, or just walking on the street. Moreover, there are different types of risks too. For instance, one type of risk called systematic risk, includes market crashes that have an impact on everyone. On the other hand, some risks like product recall are only confined to a particular company or industry and are known as unsystematic risks. Grasping these disparities is absolutely critical for making the right decisions!

What is Risk?

When it comes to finance and investing, risk is defined as the likelihood that the actual return of an investment will diverge from the expected return. It denotes the unpredictability or fluctuation in returns, and as a rule, higher risk accompanies higher reward.

Risk originates from the fact that the future results are not known with certainty because of a variety of factors such as economic, market, political, or specific to the company ones.

Types of Risk

Systematic Risk (Market Risk or Non-Diversifiable Risk):

• Definition: The risk that comes along with the whole market or market sector. It’s not possible to get rid off it through diversification.
• Types:
  • Market Risk: The risk of investments losing value because of general economic developments or other minor events affecting the whole market.
  • Interest Rate Risk: The risk that an investment’s worth will fluctuate along with the movement in the blindingly clear direction of interest rates.
  • Inflation Risk (Purchasing Power Risk): The risk that the return on investment will not have the same buying power in the future because of inflation’s effect on the purchasing power.
  • Currency Risk (Exchange Rate Risk): The risk that an investor’s asset may see its value decrease or increase as a result of exchange rate fluctuations among different currencies.
  • Political Risk: The risk that the government may take decisions, events, or conditions (like war, unrest, or changing power) that will affect an investment.

Unsystematic Risk (Specific Risk or Diversifiable Risk):

• Definition: A company-specific or industry-specific risk. It can be reduced greatly by spreading investments over multiple stocks.
• Types:
  • Business Risk: The risk that is connected to the operations of a specific company and its industrial sector. It covers factors like rivalry, consumers’ inclinations, and government interventions.
  • Financial Risk: The risk that is involved in a company’s borrowing (leverage) utilize. An organization that has taken on a lot of debt is considered more likely to default on financial commitments.
  • Operational Risk: The chance of financial loss due to internal processes, personnel, systems failing or outside events occurring (e.g., fraud, cyberattacks, supply chain disruptions).
  • Legal/Regulatory Risk: The risk of potentially damaging a company’s business due to the introduction of new laws or regulations.

Other Major Risk Categories:

• Credit Risk (Default Risk):
  • A borrower’s risk of not paying the required debt payments (either interest or principal) and being unable to pay is considered as default.
  • This is relevant to all kinds of financial instruments, such as bonds, loans, and credit.
• Liquidity Risk:
  • Asset Liquidity Risk: This type of risk is associated with an asset being unable to find a buyer in the market quickly enough, resulting in a loss (or rendering the payment impossible).
  • Funding Liquidity Risk: This risk represents a situation where a financial entity (for instance, a corporation or a bank) does not possess the influx of cash flow required to fulfill its short-term financial obligations.
• Country Risk:
  • The risk associated with investing or conducting business in another country, which includes the risk of changing politics, uncertain economies, and government default on its bonds or interfering with private obligations.
• Reinvestment Risk:
  • The possibility that cash flows coming from an investment (for example, bond interest payments) will be required to be reinvested at a lesser rate of return.
• Model Risk:
  • The risk of loss resulting from employing faulty models, either through incorrect application or underlying assumptions being inaccurate, to support business decision-making (this is especially common in activities engaged in finance and trading).
• Reputational Risk:
  • The risk of hurting an organization’s reputation, brand, or public image, thereby causing a loss of customers, revenues, or even lawsuits.
• Strategic Risk:
  • The risk that unprofitable business decisions, wrong strategies, and management’s inability to cope with industry changes (such as technological disruption) will put the organization’s goal of achieving its vision at risk.
• Compliance Risk:
  • The risk of incurring severe penalties, financial losses, or major setbacks that an organization faces if it does not follow the laws and regulations of its industry.
• Cybersecurity Risk:
  • It is a part of the operational risk category, representing the likelihood of an organization’s financial loss, disruption, or negative impact on its reputation due to the failing of its I.T. systems, mainly as a consequence of cyberattacks.
• Environmental, Social, and Governance (ESG) Risk:
  • The risk linked with a company’s moral and environmental-friendly strategies including its footprint on nature, its dependence with various stakeholders, and its governance structure. Lack of attention to ESG could mean reputational harm, receiving regulatory honchos, and lessening the interest of the investors.

Difference Between Systematic and Unsystematic Risk

Feature	Systematic Risk	Unsystematic Risk
Definition	Risk inherent to the entire market or economy.	Risk unique to a specific company or industry.
Common Names	Market Risk, Non-Diversifiable Risk.	Specific Risk, Diversifiable Risk, Unique Risk.
Scope of Impact	Affects a very large number of assets and the market as a whole.	Affects a single company, a few companies, or one specific industry.
Causes	Macroeconomic factors like inflation, interest rates, political instability, wars, and recessions.	Microeconomic factors like poor management, labor strikes, unsuccessful product launches, or competitor actions.
Controllability	Uncontrollable by an individual company.	Controllable to some extent by the company through its management decisions.
Diversification	Cannot be eliminated or reduced through diversification.	Can be eliminated or significantly reduced through diversification (holding a well-diversified portfolio).
Measurement	Measured by Beta (β). A beta shows a stock’s volatility relative to the overall market.	There is no single measure, as it is specific to each asset. It is reduced as portfolio diversification increases.
Examples	• A global financial crisis. • A central bank raising interest rates. • High inflation affecting all stocks. • A major war or political event.	• A key factory fire at a specific company. • A product recall by a single automaker. • The CEO of a tech firm resigning unexpectedly. • A new competitor disrupting one industry.
Portfolio Implication	This is the core risk an investor must accept to be in the market. It sets the baseline return expected.	A smart investor does not expect to be rewarded for taking this risk, as it can be diversified away for free.

Conclusion

Understanding risk in the grand scheme of things is really a superpower. It helps you to foresee the issues and thus make plans. The basics have been covered: risk is the chance of something going wrong, and it is pretty much everywhere in our activities. The two major types of risks have also been discussed: systematic and unsystematic. Systematic risk is the big-picture items, like economic collapse or interest rate increases which may affect the whole market. Unsystematic risk, on the contrary, is narrower, hitting certain companies or sectors through management problems or shifts in consumer tastes. The major lesson? Spotting these different types of risk not only gives you the power to make the right decisions, but also to be a winner in financial investments or just in daily life.

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