While discussing portfolio management, at the outset we need to define what risk is all about. There are two key concepts in finance viz. ‘A rupee today is worth more than a rupee tomorrow’ and ‘A safe rupee is worth more than a risky rupee’. These two ideas form the basis for all aspects of financial management. Risk can be attributed to the second statement. Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event. In everyday usage, risk is often used synonymously with the probability of a known loss. Risk is uncertainty of the income /capital appreciation or loss of both. The total risk of an individual’s security comprises two components:
- Market related risk called systematic risk which is also known as undiversifiable risk.
Systematic risk is the risk inherent to the entire market or entire market segment. Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged.
- Unique risk of a particular security is called unsystematic risk or diversifiable risk.
Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification.
For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.