Types of Investment Risk - The Risk Dichotomy
All manner of investment risk falls into one of two categories, either diversifiable (also known as non-systematic or non-market risk) or nondiversifiable (known also as systematic or market risk). If risk cannot be diversified away by increasing the number of different types of investments in a portfolio, then it is systematic. Economic activity, monetary and fiscal policy, the level of interest rates and market sentiment are difficult, if not impossible, to diversify away.
Moreover, the correlation amongst various asset classes in times of heightened market volatility historically has increased, adding another challenge to the asset allocation and risk management processes. By contrast, if risk can be mitigated through diversification between and within asset classes, then it is non-systematic or diversifiable. Please note that the recommended means of risk reduction that follow are instructive and meant to deepen the reader's understanding. The investor's needs and circumstances, as embodied in the Investment Policy Statement (a blueprint for how the portfolio is to be managed), govern the portfolio management process. Each definition of risk indicates whether or not it is diversifiable.
An understanding of various types of risks is critical when evaluating the suitability of an investment for a client. Know and understand risk, and whether or not it is diversifiable. Expect questions asking the candidate to identify the most significant risk associated with an investment or the risk with which a particular investor should be concerned.