Unsystematic Risks

Unsystematic Risk
While diversification does not reduce systematic risk, it does reduce the unsystematic risks we will look at next. Unsystematic risk relates to an issuer or industry space, as opposed to the overall market. The risk that regulators will increase regulations on the automobile industry is not system-wide, affecting only a few issuers and industries. Diversifying a portfolio reduces these more specific risks by spreading them out among stocks of different issuers operating in different industry sectors.
Or, a municipal bond investor might diversify her holdings geographically to avoid the risk that an area of the country could be hit by a weather event or an economic slump. Although municipal bond investors generally seek safety, they can also enhance their yield by purchasing some lower-rated municipal bonds with some percentage of the account assets. After all, even conservative bond funds frequently put 20'% or so in so-called "junk" bonds issued by corporations or municipalities.

Municipal bonds come in many flavors, also, so investors might purchase bonds used for many different purposes some general obligation and some revenue to avoid being too dependent on just toll roads, for example, or airport revenues. While an individual bond investor could use a registered representative to put together a diversified portfolio, more likely the registered representative would find a mutual fund portfolio already designed to achieve what the investor is looking for.

Business Risk
Buying stock in any company presents business risk. Business risk includes the risk of competition, a labor strike, the release of inferior products, and the risk of obsolescence, which is the risk that a company's offerings suddenly become a thing of the past, or obsolete. Shareholders in companies producing telegraph equipment, typewriters, and 8-track players all felt the sting of obsolescence risk.
Nowadays, investing in a newspaper carries more risk of obsolescence than investing in a company that manufactures underwear. The risk of poor management, of better competitors, or of products becoming obsolete are all part of business risk.
In other words, the stock we own is only as solid as the businesses who issued it. So, we also need to diversify the portfolio so that it's not all subject to the same type of business risk. Airlines, retailers, and financial services companies, for example, would face different business risks. And, this shows how inherently risky stock investing is. Investors can get hurt by the individual companies they invest in, as well as the fact that the stock market overall can drop in value, whether the individual companies do well or not.

Legislative or Regulatory Risk
Legislative or regulatory risk means that if industry regulations or the tax code changes, certain securities could be negatively affected. If the federal government announced that all car makers must get 35 mpg for their large SUVs and pickup trucks by the following year, this would probably depress the value of certain stocks and bonds issued by companies including Ford and GM. Or, what if an investor bought a portfolio of tax-exempt municipal bonds, and then Congress decided to eliminate the exemption for municipal bond interest? Most likely, investors would dump their municipal bonds, forcing the market prices down.
Different industries are subject to different regulatory risks, so diversification can protect the investor from legislative risk somewhat. For this reason, mutual funds focusing on just one industry sector are riskier than the typical fund that is broadly diversified.
And, not all industries are harmed by increased regulations. For example, when legislation such as Dodd-Frank and the American Healthcare Affordability Act is passed, the need for consultants who can guide companies through the changes increases. When the tax code becomes more complex, CPAs and other tax-planning or tax-law professionals typically have more work to do, possibly at higher rates.

Credit/Default Risk
Credit risk is the risk that the issuer of a bond will be unable to pay interest or return principal to the bondholders. U.S. Treasury securities have little or no default risk, but some municipal securities and most corporate bonds carry default/credit risk to some degree. Even if the issuer never misses a payment, if S&P and Moody's downgrade their credit score, the market value of the bonds would also drop.
The terms credit risk and default risk are typically used interchangeably.

Liquidity Risk
Liquidity is the ability to quickly turn an investment into cash without having to sell at a loss. Government securities are more liquid than municipal securities, and listed stocks more liquid than those trading in the non-Nasdaq OTC market. So, thinly traded securities have liquidity risk compared to securities with more active secondary markets. Insurance companies invest their net premiums in liquid, investment-grade bonds because they often have to liquidate their portfolio to pay claims after, say, a hurricane or flood. If they had to find buyers for illiquid junk bonds or real estate holdings, they would likely end up selling at unfavorable prices.

Opportunity Cost
If we pass up an investment opportunity to make 5%, our opportunity cost is 5%, and we need to do better than 5% with the opportunity we choose instead. If we could have made 5% and end up making 7% with another investment, we made 2% better than your opportunity cost.


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