Question

Before investing any money, what five things should you do first? What is systematic risk? Will the investment in two unrelated domestic stocks, rather than one stock, increase or decrease your systematic risk exposure?

Luc has urged Marcelino to invest for the long term using a diversified approach. Marcelino is skeptical. Explain why Luc is probably correct.

Answer 1

1. 5 things to check are -

• Checking financial standing (debt taken, income sustainability, etc)
• uses and need for income
• Understand Investment Options (stock market, bond market, real estate etc.)
• Checking Financial Planning (whether a financial planner needed)
• Finding all available and suitable investment options/products

2.  Systematic risk is the market risk caused by macroeconomic factors within an economy and hence beyond the control of anyone. It is an undiversifiable risk.

3. Diversification can't reduce systematic risk exposure. It can only reduce unsystematic risk. So, investment in two unrelated domestic stocks will neither increase or nor decrease systematic risk exposure.

4. Total risk =  systematic risk + unsystematic risk.

As systematic risk can't be reduced and hence rewarded in terms of the required rate. we can But unsystematic risk can be reduced and hence not rewarded. So, attempt should be made to reduce unsystematic risk.

Now as Diversification reduces unsystematic risk, So, Marcelino should invest for the long term using a diversified approach.