Question

aked beans a lot more predictable than shares BY SIMON HOYLE

11 March 2006

The Sydney Morning Herald

THE price of a tin of baked beans doesn't change much from day to day. The price of

a company’s shares, on the other hand, can change quite a lot. In investment terms, the price of the baked beans isn't as volatile as the share price.

While you might have a good idea of how much a tin of baked beans will cost you whenever you go 10 buy one, you can't be as certain about the price of a share. IBut there are ways you can make educated guesses about what the price of a share might do over a period of time. In other words, you can make educated guesses about the range of likely future outcomes, and hence about likely future volatility. A common way of measuring an asset's riskiness, or volatility, is the "standard deviation" of the asset's returns. Standard deviation is a statistical method of calculating the most likely range of returns from an asset. It is the method that analysts use to make long-term predictions from short-term data.

If you were to plot the returns from an asset on a graph, where the horizontal axis is the return the asset achieves every day, week or month, and the vertical axis is the number of times that return occurs, you'd get what's called a "distribution curve". This looks like a bell, and for that reason it's also sometimes known as a bell curve. What a bell curve tells you is that an asset's returns tend to be clustered around a certain number, and the further from that number you move along the horizontal axis, the fewer times the returns tend to crop up.

Calculating the standard deviation of an asset's returns tells you how far from the average return you have to move in order to include about two thirds of the range of an asset's returns. Moving two standard deviations from the average means you can cover about 95 per cent of the range of returns. In other words, you can say, with a high degree of certainty, what the range of an asset's returns will be.

"For example, an annualised volatility of 8 per cent together with an expected return of 20 per cent over the year can be used to produce an interval of possible return outcomes for the year," CommSec says.

"In this example there is an approximately two-thirds chance that the outcome after one year is 20 per cent, plus or minus 8 per cent (that is, 12 per cent to 28 per cent), and approximately a 95 per cent chance that the outcome will fall in an interval twice as wide (that is, 4 per cent to 36 per cent)."

A higher standard deviation means the likely outcomes range a long way from the average, and a lower standard deviation means the possible outcomes are more tightly concentrated around the average.

Part one requires qualitative explanations that display your understanding of the concepts of risk and return. The article of Simon Hoyle gives some understanding of the concepts of risk and return. However, it was published in a newspaper where the target readers were not all educated in finance. You are required to answer the following questions while providing deeper insights about the concepts of risk and return than those that are provided in the article.

Read the article by Simon Hoyle above and answer question the below question :

QUESTION(200 words)

Explain the distinction between Systematic and Unsystematic Risk? How can investors avoid each one of those risk?

Answer 1

RISK RETURN TRADE OFF

The risk is the degree of uncertainty in any stage of life. For instance, while crossing the road, there is always a risk of getting hit by a vehicle if precautionary measures are not undertaken. Similarly, in the area of investment and finance, various risks exist since the hard-earned money of individuals and firms are involved in the cycle.

RISKS-

• Systematic Risk does not have a specific definition but is an inherent risk existing in the stock market. These risks are applicable to all the sectors but can be controlled. If there is an announcement or event which impacts the entire stock market, a consistent reaction will flow in which is a systematic risk. E.g., if Government Bonds is offering a yield of 5% in comparison to the stock market, which offers a minimum return of 10%. Suddenly, the government announces an additional tax burden of 1% on stock market transactions; this will be a systematic risk impacting all the stocks and may make the Government bonds more attractive.

Systematic risks are difficult to be mitigated since these are inherent in nature and not necessarily controlled by an individual or a group. There is no well-defined method for handling such risks. Still, as an investor, one can consider diversification into various securities to perhaps reduce the impact of idiosyncratic situations, causing a ripple effect of such risks.

• Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is also known as “Specific Risk,” “Diversifiable risk,” or “Residual Risk.” These are risks which are existing but are unplanned and can occur at any point in causing widespread disruption. E.g., if the staff of the airline industry goes on an indefinite strike, then this will cause risk to the shares of the airline industry and fall in the prices of the stock impacting this industry.

The existence of unsystematic risks means the owner of a company’s securities is at risk of adverse changes in the value of those securities due to the risk caused by the organization. Diversification is one of the options to reduce the impact, but it will still remain subject to Systematic risk that impacts the whole market. More is the diversification; lower will be the residual risk in the overall position. Unsystematic risk is measured and managed through the implementation of various risk management tools, including the derivatives market. Investors can be aware of such risks, but various unknown types of risks can crop up at any time, thereby increasing the level of uncertainty.

One should keep in mind the below formula, which in a nutshell highlights the importance of these 2 types of risks faced by all kinds of investors:

Systematic Risk and Unsystematic Risk Differences

Let us understand the differences between Systematic Risk vs. Unsystematic Risk in detail:

1. Systematic risk is the probability of a loss associated with the entire market or the segment. Whereas, Unsystematic risk is associated with a specific industry, segment, or security.
2. Systematic risk is uncontrollable in nature since a large scale, and multiple factors are involved. Whereas, unsystematic risk is controllable as it is restricted to a particular section. Unsystematic risks are caused due to internal factors that can be controlled or reduced in a relatively short time.
3. Systematic Risk affects many securities in the market due to widespread impact such as interest rate decreases by the Central Bank of a country. In contrast, Unsystematic risk will affect the stock/securities of a particular firm or sector, e.g., the strike caused by the workers of the Cement industry.
4. Systematic Risk can be substantially controlled through techniques like Hedging and Asset allocation. Conversely, unsystematic risk can be eliminated through diversification of a portfolio.
5. Systematic Risk is divided into 3 categories, i.e., Interest Rate Risk, Purchasing Power risk, and Market risk. In contrast, Unsystematic risk is bifurcated into two broad categories, namely Business Risk and Financial Risk.

Systematic Risk vs. Unsystematic Risk (Comparison Table)

Basis for Comparison between Systematic Risk vs. Unsystematic Risk	Systematic Risk	Unsystematic Risk
Meaning	Risk/Threat associated with the market or the segment as a whole	Hazard associated with specific security, firm, or industry
Impact	A large number of securities in the market	Restricted to the specific company or industry
Controllability	Cannot be controlled	Controllable
Hedging	Allocation of the assets	Diversification of the Portfolio
Types	Interest Risk and Market Risk	Financial and Business risk
Responsible Factors	External	Internal
Avoidance	Cannot be avoided	It can be avoided or resolved at a quicker pace.

Conclusion

Any investment will have inherent risks associated with it, which cannot be avoided. Systematic Risk vs. Unsystematic Risk highlights these factors which have to be accepted while making any investment.

These risks do not have any specific definition, but it will be a part of any financial investment. Though both Systematic Risk and Unsystematic Risk these types of risks cannot be completely avoided, an investor needs to be vigilant and periodically re-balance their portfolio or diversify their investments so that if any catastrophic event takes place, the investor can be less impacted in case of adverse events but also maximize gains in case of positive announcements.