Proper diversification can nearly eliminate unsystematic risk. If an investor owns just one stock or bond and something negative happens to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 30, or 40 individual investments, the damage done to the portfolio is minimized.
The important concept of unsystematic risk is that it is not correlated to market risk and can be nearly eliminated by diversification.
Probability and Expected Value
The expected value or return of a portfolio is the sum of all the possible returns multiplied by the probability of each possible return. One form of risk is the amount of deviation and the probability of that deviation from the expected return.
Portfolio risk is reduced by mitigating systematic risk with asset allocation, and unsystematic risk with diversification. Mitigation of systematic and unsystematic risk allows a portfolio manager to put higher risk/reward assets in the portfolio without accepting additional risk. This is called portfolio optimization.
In other words, a manager is willing to accept a given amount of risk. The total risk of the portfolio is lowered through proper asset allocation and diversification. Now the the manager can add more aggressive investments to the portfolio and still maintain the given amount of risk he is willing to accept.
Systematic and unsystematic risks can be partially mitigated with risk management solutions such as asset allocation, diversification, and valuation timing. Used properly, a manager can increase portfolio returns and/or reduce risk to optimize an investment portfolio.
This article was republished with permission from Arbor Investment Planner.