Total Risk in Finance

Components of Total Risk

• Total risk is made up of two main types:
  • Systematic Risk (Market Risk)
  • Unsystematic Risk (Firm Risk)

Systematic Risk

• Affects all firms, hence termed market risk.
• Influences the entire market.
• Examples include:
  • Exchange rate
  • Interest rate
  • Inflation rate
  • Unemployment rate
  • Business cycle stages
• Characteristics:
  • It is unavoidable.
  • Also known as non-diversifiable risk.
• Measurement:
  • Measured through Beta.

Unsystematic Risk

• Affects specific firms or sectors.
• Not all firms are affected, hence termed firm risk.
• Example: Government imposing higher taxes on polluting industries.
• Characteristics:
  • It is avoidable, also known as avoidable risk.
  • Also called diversifiable or idiosyncratic risk.
• Avoidance:
  • Can be avoided through diversification.
  • Strategy: Invest in different sectors and within each sector, invest in different companies.

Measuring Risk

• Total Risk Measurement:
  • Measured through Volatility or Standard Deviation.
  • Volatility (finance) and standard deviation (statistics) are synonymous, both symbolized by sigma (σ).

Diversification and Risk

• The concept: "Don’t put all your eggs in one basket."
• Diversification reduces unsystematic risk.
• Empirical studies suggest that investing in around 30 securities that are weakly or negatively correlated can significantly decrease unsystematic risk.
• Systematic risk remains regardless of diversification.

Graphical Representation

• X-axis: Number of securities
• Y-axis: Volatility
• Observation: Increasing the number of securities decreases unsystematic risk but does not affect systematic risk.