Scam 1992 – India’s greatest ever web series made on Harshad Mehta’s stock market scam has a striking dialogue that became popular in pop culture. The dialogue ‘risk hai to Ishq hai’ (if there is a risk, there is love) has portrayed the unflinching side of Harshad Mehta, who is aware of the uncertainties in the stock market and acknowledges the same.
Risks known and unknown are inevitable in the stock market which can be broadly classified into two- systematic risk and unsystematic risk. The total risk involved in a portfolio is an addition of the systematic and unsystematic risks.
What is systematic risk?
Systematic risks in the stock market are caused by factors that are beyond the control of a company or individual. These risks are unpredictable and are difficult to avoid. Systematic risks do not affect a particular stock or industry but the overall market. It causes lower investment value over a specific period of time affecting the large sections that can be corrected either by hedging or by asset allocation strategy.
Therefore, all investments are prone to systematic risk. The impact of systematic risk might cause the investment value to decline over a specific period of time due to economic changes affecting the large sections of the market.
Types of systematic risk
Four kinds of risks fall under systematic risk.
Market risk:
Market risk happens when a large number of investors follow the direction of the market that causes stock prices to move together. If the market is declining, the investor’s fear of losing money also brings down the share prices of reputed companies.
Interest risk:
It arises due to variations in market interest rates that affect the fixed income securities as bond returns are inversely related to the market interest rate. There are two more components to interest risk that work contrary to each other- Price and reinvestment risk. Price risk happens when changes in stock prices are associated with a change in interest rate whereas reinvestment risk is linked with the dividend.
Purchasing power risk:
Purchasing power risk takes place due to inflation. The increase in prices lowers the investment giving lower returns.
Exchange rate risk:
This risk is associated with fluctuations in the value of the foreign currency. It impacts the stocks of companies that deal with exports or buy imported raw materials or products.
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Risks in the stock market are of types - systematic risk and unsystematic risks.
What is unsystematic risk?
Unsystematic risk is any risk that is specific to a company. Such risks occur due to incorrect entrepreneurial decisions that disrupt the normal functioning of the business. But, unlike systematic, unsystematic risks are unavoidable. Various factors cause such risks to occur:
Flaws in the business model
Wrong strategies adopted for growth, such as wrong product-consumer fit causing a dip in sales.
Reputational risk – for example, if the brand or product fails to comply with the regulations, any advertisements or campaign hurting the sentiments, bad employer-employee relations, labour strikes or unethical practices, etc. can impact the share prices.
Liquidity crunch in the business
The occurrence of accidents or disasters such as heavy rainfalls affecting the acacia trees producing rubber, essential for producing tyres, thereby affecting the tyre manufacturing companies.
Systematic risk vs unsystematic risk
How can the risks be mitigated?
Since, systematic risks cannot be controlled and avoided, the only way to mitigate this risk is by allocation of assets. Asset allocation is an investment strategy that helps to balance risk and reward in an investment portfolio by determining how much to invest in stocks, bonds and cash.
Whereas, in unsystematic risk, the investor needs to diversify the portfolio. Diversification includes investing in stock from different industries as well as other investments such as bonds, commodities, fixed income and real estate. The investment in various assets will reduce the investor’s risk of a permanent loss of capital and lessen the overall risk profile.
