There are always risks in the business world. Understanding these risks allows us to seek the most effective approaches to mitigate them. What are these risks and how can they be classified?

There are two main components of risk: systematic and unsystematic. Let’s explore each risk and learn the best way to mitigate it.

Systematic risk

Systematic risk, also known as “market risk” or “undiversifiable risk,” is the result of uncontrollable, external variables that are not industry or security specific. Generally unavoidable, it affects the entire market causing the prices of all securities to fluctuate. Risk can be attributed to a number of broad economic factors, such as inflation, changes in interest rates, currency fluctuations, recessions, etc.

Since systematic risks cannot be controlled, investors can avoid them by staying away from all risky investments.

Financial planning: systematic risk mitigation

Systematic risks can be mitigated with certain courses of action. How can they be mitigated?

Asset allocation can partially mitigate systematic risks. Owning different categories of assets (ie bonds, cash, commodities, etc.) with low or no correlation helps because they affect macroeconomic factors differently; some categories of assets may increase and others may decrease.

Asset allocation must also be adjusted based on valuations. Investments that are overpriced should be avoided or owned less. By mitigating systematic risks within a diversified portfolio, cash may be the most important and least appreciated asset category.

Another way to reduce systematic risk is through hedging. Investors can use options such as buying hedging options on their securities. A protective put option is a risk management strategy that investors use to hedge against the loss of unrealized gains. The sale value will increase if the value of the securities falls. However, options are time-limited, and once they expire, investors must purchase new ones to stay covered.

Unsystematic risk

In contrast, unsystematic risk refers to risk factors that are specific to a company, industry, and sector, and that can be controlled to some degree. These factors include a business’s management, financial practices, financial health, and its competitive position in the marketplace.

Financial planning: mitigating unsystematic risks

Unsystematic risk can be reduced through diversification. To achieve this, the investor can diversify their product portfolio so that income does not depend on just a few products. Much of risk is reduced when an investor’s risk is spread across different industries (such as banking or healthcare) and asset classes. For example, if an investor has a diversified portfolio of more than 10 individual investments instead of just one, the damage done to his portfolio is minimized when something negative happens to some of the companies.

Again, unsystematic risk can almost be eliminated through diversification, as it is not correlated with market risk.

Both systematic and unsystematic risks are an integral part of business. Through the risk management solutions mentioned above, these risks can be partially mitigated and investors will be able to see an increase in portfolio returns and an optimization in the investment portfolio.