Section 14.2 – Reducing Systematic and Nonsystematic Risk

  • There are two broad categories of investment risk:

    • Systematic risk → built into the overall market system (cannot be avoided entirely)

    • Nonsystematic risk → specific to a company, industry, or type of investment (can be reduced)

  • Investors use hedging and portfolio management techniques to manage or minimize these risks.

🌀 Reducing Systematic Risk:

  • Systematic risk affects the entire market (e.g., recessions, inflation, wars).
    While it cannot be eliminated, it can be managed through:

    1. Hedging

    • Involves buying a security that moves opposite to the portfolio being protected.

    • Commonly done using options (especially index puts).

    Example:
    To offset market risk in a portfolio of large-cap stocks, an advisor buys put options on the S&P 500 index.
    If the market falls, the value of the put options rises—reducing losses in the overall portfolio.

    ➡️ Goal: Limit downside exposure to broad market declines.

Portfolio Rebalancing:

  • A component of asset allocation strategy.

  • Involves periodically adjusting a portfolio by selling investments that have increased in value and buying those that have decreased.

  • Keeps the portfolio aligned with the desired risk and return profile.

  1. Example:
    If stocks outperform and now make up too large a portion of the portfolio, the manager sells some stocks and buys bonds to rebalance.

    ➡️ Result: Produces steadier returns and lower volatility than holding only one asset class.

💼 Reducing Nonsystematic Risk:

1. Hedging

  • Similar to systematic risk hedging, but applied to individual securities.

  • The investor purchases a security that moves opposite to the one being hedged.

Example:
An investor who owns ABC Company stock can hedge by buying ABC put options.
If the stock falls, the put gains value and helps offset losses.

➡️ Works well for small portfolios but becomes impractical when holding many securities.

2. Diversification

  • The most effective way to reduce nonsystematic risk.

  • Spreading investments across many different securities, sectors, and asset types reduces the impact of any single loss.

Example:
A diversified portfolio with technology, healthcare, utilities, and bonds will be less affected if one industry underperforms.

➡️ Key Principle: Diversification smooths returns and minimizes company- or sector-specific losses.

Reduce Risk

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Reduce Risk 〰️

Quick Comparison Chart

Type of Risk / How to Reduce it / Description

  • Systematic / Hedging & Portfolio Rebalancing / Market-wide risk (e.g., inflation, war, interest rates)

  • Nonsystematic / Hedging & Diversification / Company- or industry-specific risk

✺ Review questions ✺

  • Hedging and portfolio rebalancing.

  • By purchasing securities (like options) that move in the opposite direction of the overall portfolio to offset potential losses.

  • To take profits and maintain the portfolio’s original asset allocation, reducing volatility.

  • Systematic risk cannot be eliminated by diversification, but nonsystematic risk can.

  • Diversification.

  • Hedging.

  • Because managing hedges for many different securities becomes complex and costly.

  • To maintain the desired mix of assets, control risk, and produce steadier returns.