Systematic vs Unsystematic Risk

Systematic Risk (Market Risk / Non-Diversifiable)

Affects the ENTIRE market — CANNOT be diversified away

• Market risk: Overall market decline (bear market)
• Interest rate risk: Bond prices fall when rates rise
• Longer maturity = MORE interest rate risk
• Inflation risk (purchasing power risk): Returns don't keep up with inflation
• Fixed-income most vulnerable; TIPS protect against this
• Currency risk (exchange rate risk): Foreign investment values change with exchange rates
• Political/Legislative risk: Government actions affect investments
• Reinvestment risk: Reinvesting at lower rates
• Highest for callable bonds and high-coupon bonds
• Zero-coupon bonds have ZERO reinvestment risk (no coupons to reinvest)

Unsystematic Risk (Diversifiable)

Affects a SPECIFIC company or industry — CAN be reduced through diversification

• Business risk: Company-specific problems (bad management, product failure)
• Financial risk (credit/default risk): Company can't pay debts
• US Treasury has virtually ZERO credit risk
• Regulatory risk: Industry-specific regulations change
• Liquidity risk: Can't sell quickly without significant price impact
• Thinly traded stocks, non-traded REITs, DPPs

Other Important Risks

• Call risk: Issuer calls bonds when rates drop — investor loses high coupon
• Prepayment risk: Mortgage holders refinance early (affects MBS/GNMA)
• Opportunity cost: Return given up by choosing one investment over another
• Concentration risk: Too much invested in one security/sector