Tuesday, 2 September 2008

Types of Risk (Total risk = Unique risk + Market risk)

Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

Unique risk (Diversifiable risk or Unsystematic risk)

The unique risk of security represents that portion of its total risk which stems from firm-specific factors like
  • the development of a new product,
  • a labour strike, or
  • the emergence of a new competitor.
Events of this nature primarily affect the specific firm and not all firms in general.

Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.

Market risk (Non-diversifiable risk or Systematic risk)

The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like
  • the growth rate of GDP,
  • the level of government spending,
  • money supply,
  • interest rate structure, and
  • inflation rate.

Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.

Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.

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