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Unsystematic Risk

Anna knows more about systematic risk of winfit, also called general market risk. However, she wants to understand both risks before buying winfits stocks. Hence, she is wondering about the meaning of winfits unsystematic risk.

Unsystematic risk describes an industry or company specific risk that is part of each investment. This risk concerns a specific company and is therefore also called “specific or risidual risk”.

In contrast to systematic risk, diversification (buying different assets in different industries) can reduce unsystematic risk.

A unsystematic risk for winfit is the increase of the price for cotton, since most of their sports clothes are made out of this material. If the cotton price increases, winfits profit margin decreases. In order to minimize this risk, Anna could also buy commodities (like cotton).

This diversification reduces the unsystematic risk, but not the systematic risk. While looking at the overall risk of an investment, the major parts are specific, unsystematic risks while a smaller portion includes the systematic risk.

Typical examples for unsystematic risk include new competitors, new law regulations or the price increase of raw materials.   

Systematic Risk

As you know from this article, Anna loves sports. Meanwhile, she did some market research and finally decided to buy 3 stocks of winfit. Winfit is a publicly listed company which sells all kind of sports equipment. Anna’s winfit favourite is the wearable smartwatch with an heart rate tracker. If you wonder why companies are publicly listed, check out this article.   

While Anna did her research, she stumbled upon the terms systematic risk and found the following definition:

Systematic Risk is the general market risk. This systematic risk concerns the entire market and since it can’t be reduced by buying different stocks, this risk is also called “non-diversifiable risk”.

Everyone who invests in the market, assumes this general market risk. Systematic risk is caused by events, that influence the entire market such as wars, major political decisions or natural disasters. In the week after hurricane Irma hit Florida, the S&P 500 fell almost 2%. S&P 500 represents 500 large companies that are listed on the American Stock markets.

Anna asked herself “Does winfit really have the same systematic market risk as any other company? For example when Irma hits Florida, winfit might not be affected as much as insurance companies?”

And Anna was right. Only very few companies have the exact same systematic risk as the market does.

Beta measures the amount of systematic risk in an investment. It’s a measure for correlation between investment and market.

A Beta > 1 means that an investment has more systematic risk than the market.

A Beta < 1 means that an investment has less systematic risk than the market.

A Beta = 0 means that an investment has the same systematic risk as the market.

As previously mentioned, the term market refers to indices like S&P 500, DAX or Russell 2000. Continue reading, if you’d like to learn more about unsystematic risk.

Investment #4 – ETFs

Victoria is an environmentalist, and is really interested in the green energy sector. Because of increasing Global Warming and other research, she believes the green energy sector will grow a lot over the next decade.

Victoria is interested in investing the little money she has in one of her favourite green companies. But the problem is… there are just too many to choose from! So, Victoria decides to invest in a green energy ETF.

ETF (exchange traded fund)

An investment fund that trades on the stock market. Just like mutual funds, it is a pool of money from different investors that purchases and invests in a variety of securities.

Just like mutual funds, ETFs invests the fund’s money into different securities (stocks, bonds, etc.), providing investors with diversification. In addition, ETFs are traded on the stock exchange, making them very easy to buy and sell.

So why would Victoria chose to invest in an ETF over other alternatives? Well, there are a variety of ETFs to choose from; some ETFs invest in stocks & bonds, some replicate the performance of an entire stock market (stock index), and others replicate the performance of a specific industry sector… In Victoria’s case, she can invest in a Green Energy ETF, which replicates the performance of all of her favourite green energy companies put together.

Overall, Victoria likes ETFs because:

  • It’s an easy way to get a diversified portfolio (less risky)
  • It’s easy to buy and sell on the stock market
  • It allows her to invest in a wide variety of investments
  • There are no management fees and very low transaction fees  

So how will this let Victoria to grow her money? When the fund’s assets (stocks, bonds, etc.) rise in value, so does the value of her ETF shares. In this case, she can sell her shares at a profit. The ETF also pays out dividends to Victoria, which is a portion of the fund’s earnings.

Of course, if the fund’s assets go down in value, so does the value of the ETF shares. Therefore, Victoria makes sure to do research in advance to ensure that the fund’s securities (companies) are good ones!

 

Which industry would you invest your money in?