Understanding Investment Risk Before Building a Portfolio
Every investment carries some level of risk. But not all risk is the same.
When building an investment portfolio, it can be helpful to understand two broad categories of risk: systematic risk and unsystematic risk. These terms may sound technical, but the concepts are straightforward.
Systematic risk is the type of risk that affects the broader market. Unsystematic risk is the type of risk tied to a specific company, industry, or investment.
Understanding the difference between the two can help investors make more informed decisions about diversification, asset allocation, and how much risk they are comfortable taking.
What Is Systematic Risk?
Systematic risk, sometimes called market risk, is the risk that affects the overall financial markets or large segments of the economy.
This type of risk cannot be eliminated simply by owning more stocks or spreading money across different companies. When the entire market is reacting to a major economic or global event, most investments may be affected in some way.
Examples of Systematic Risk
- Interest rate changes: Rising or falling interest rates can impact stocks, bonds, real estate, borrowing costs, and business activity.
- Inflation: Higher inflation can reduce purchasing power, pressure company profits, and influence Federal Reserve policy.
- Recessions: During an economic slowdown, many companies may see lower earnings, and investors may become more cautious.
- Geopolitical events: Wars, trade disputes, elections, or global instability can create uncertainty across financial markets.
- Broad market declines: Events that cause investors to sell risk assets broadly can impact even high-quality investments.
The key point is this: systematic risk is not tied to one company or one sector. It is part of investing in the broader market.
What Is Unsystematic Risk?
Unsystematic risk, sometimes called specific risk or company-specific risk, is risk tied to a particular company, industry, or investment.
Unlike systematic risk, unsystematic risk can often be reduced through diversification. If one company performs poorly, a diversified portfolio may be less affected because the investor is not relying too heavily on that one holding.
Examples of Unsystematic Risk
- Poor management decisions: A company’s leadership may make strategic mistakes that hurt profitability or investor confidence.
- Product recalls: A defective product or safety issue can damage a company’s reputation and financial performance.
- Earnings disappointments: If a company reports weaker-than-expected results, its stock price may decline.
- Industry disruption: New technology, changing consumer preferences, or regulatory changes may negatively affect a specific industry.
- Legal or regulatory issues: A lawsuit, compliance failure, or investigation can create risk for a specific company.
The key point is that unsystematic risk is more concentrated. It comes from owning too much of one company, sector, industry, or investment type.
Why the Difference Matters
The distinction between systematic and unsystematic risk matters because each type of risk is managed differently.
You generally cannot diversify away systematic risk. If the entire stock market declines because of a recession, inflation concerns, or rising interest rates, most stock investments may be affected. However, you can manage your exposure to systematic risk through thoughtful asset allocation.
On the other hand, unsystematic risk can often be reduced by avoiding unnecessary concentration. Instead of relying heavily on one stock, one sector, or one narrow investment idea, investors can spread exposure across different companies, industries, and asset classes.
In simple terms: diversification helps reduce unsystematic risk. Asset allocation helps manage systematic risk.
How Asset Allocation Helps Manage Risk
Asset allocation is the process of deciding how much of a portfolio should be invested in different asset classes, such as stocks, bonds, cash, and other investments.
A younger investor with a long time horizon may be comfortable with a higher allocation to stocks. Someone nearing or in retirement may need a more balanced approach that considers income needs, market volatility, and the possibility of needing to draw from the portfolio during a downturn.
Asset allocation can help answer questions such as:
- How much market risk should I take?
- How much stability do I need?
- How much of my portfolio should be in stocks, bonds, cash, or other investments?
- Am I overly concentrated in one company, sector, or investment style?
- Does my portfolio match my financial plan?
The goal is not to eliminate risk entirely. That is not realistic. The goal is to take the right kinds of risk for your situation.
Diversification and Unsystematic Risk
Diversification is one of the most common tools for reducing unsystematic risk.
For example, owning stock in a single company exposes an investor to that company’s unique risks. If the company has an earnings disappointment, product recall, management change, or legal issue, the investor may experience a significant loss.
By contrast, owning a diversified mix of investments can reduce the impact of any one company’s poor performance.
Diversification may include spreading investments across different companies, industries, sectors, asset classes, geographic regions, and investment styles.
Diversification does not guarantee a profit or protect against loss, but it can help reduce the risk of being overly dependent on one investment outcome.
Asset Allocation and Systematic Risk
While diversification can help with company-specific risk, systematic risk requires a broader planning approach.
For example, if stocks decline broadly because of a recession or rising interest rates, simply owning many different stocks may not fully protect the portfolio. In that situation, the overall stock allocation matters.
That is where asset allocation becomes important.
A portfolio that includes a mix of stocks, bonds, cash, and other investments may behave differently than a portfolio invested entirely in stocks. The right mix depends on the investor’s goals, time horizon, income needs, risk tolerance, and risk capacity.
For retirees or those approaching retirement, this becomes especially important because market downturns can have a greater impact when withdrawals are being taken from the portfolio.
Risk Tolerance, Risk Capacity, and the Need to Take Risk
A good investment strategy should consider more than just how much risk an investor feels comfortable taking. It should also consider:
- Risk tolerance: How much market volatility can you emotionally handle?
- Risk capacity: How much risk can your financial plan afford to take?
- Need to take risk: How much growth does your plan require to support your goals?
These three items are not always the same. An investor may be comfortable taking a lot of risk, but their financial plan may not require it. Another investor may dislike volatility, but their long-term goals may require some exposure to growth assets.
Understanding systematic and unsystematic risk can help make this conversation more practical and less emotional.
A Simple Example
Imagine two investors.
Investor A owns a large amount of stock in one company. If that company has a major problem, Investor A’s portfolio may suffer significantly. That is unsystematic risk.
Investor B owns a diversified portfolio of many companies across different sectors, along with bonds and cash. Investor B still faces market risk, but the portfolio is not dependent on the success of one company. The unsystematic risk has been reduced.
However, if the entire stock market declines, both investors may still feel the impact. That is systematic risk.
This is why both diversification and asset allocation matter.
Building a Portfolio Around Your Financial Plan
A portfolio should not be built around headlines, short-term predictions, or last quarter’s returns. It should be built around the financial plan.
That includes understanding your retirement timeline, income needs, tax situation, emergency reserves, comfort with volatility, required rate of return, and legacy or estate planning goals.
When the financial plan comes first, asset allocation becomes more intentional. The investment strategy is then designed to support the plan, rather than reacting to every market movement.
Final Thoughts
Systematic and unsystematic risks are both part of investing, but they are not managed the same way.
Systematic risk is broad market risk. It cannot be eliminated through diversification alone, but it can be managed through thoughtful asset allocation.
Unsystematic risk is company-specific or investment-specific risk. It can often be reduced by diversifying across companies, sectors, and asset classes.
For investors nearing retirement, already retired, or simply trying to make better financial decisions, understanding these risks can help create a more resilient investment strategy.
A well-built portfolio should not only reflect what is happening in the market. It should reflect your goals, your financial plan, and the level of risk that makes sense for your situation.
Whether you are a do-it-yourselfer, working with another advisor or just checking us out
If you are unsure whether your portfolio is properly diversified or aligned with your financial plan, now may be a good time to review it.
At Genesis Wealth Management Group, we help individuals and families evaluate their investments in the context of their broader financial goals, retirement income needs, and risk capacity.
Schedule a discovery call or portfolio review to see whether your current allocation still fits your plan.
Disclosure
All investing involves risk, including the possible loss of principal. Diversification and asset allocation do not guarantee a profit or protect against loss. This article is for educational purposes only and should not be considered individualized investment, tax, or legal advice. Please consult with the appropriate professional regarding your specific situation.
