Any kind of investment we make is subject to risk. In fact we get return on our investment purely and solely because at the very beginning we take the risk of parting with our funds, for getting higher value back at a later date. Partition itself is a risk.
Well known economist and Nobel Prize recipient William Sharpe tried to segregate the total risk faced in any kind of investment into two parts - systematic (Systemic) risk and unsystematic (Unsystemic) risk.
Systematic risk is that risk which exists in the system. Some of the biggest examples of systematic risk are inflation, recession, war, political situation etc.
Inflation erodes returns generated from all investments e.g. if return from fixed deposit is 8 per cent and if inflation is 6 per cent then real rate of return from fixed deposit is reduced by 6 per cent.
Similarly if returns generated from equity market is 18 per cent and inflation is still 6 per cent then equity returns will be lesser by the rate of inflation. Since inflation exists in the system there is no way one can stay away from the risk of inflation.
Economic cycles, war and political situations have effects on all forms of investments. Also these exist in the system and there is no way to stay away from them. It is like learning to walk.
Anyone who wants to learn to walk has to first fall; you cannot learn to walk without falling. Similarly any one who wants to invest has to first face systematic risk; there can never make any kind of investment without systematic risk.
Another form of risk is unsystematic risk. This risk does not exist in the system and hence is not applicable to all forms of investment. Unsystematic risk is associated with particular form of investment.
Suppose we invest in stock market and the market falls, then only our investment in equity gets affected OR if we have placed a fixed deposit in particular bank and bank goes bankrupt, than we only loose money placed in that bank.
While there is no way to keep away from risk, we can always reduce the impact of risk. Diversification helps in reducing the impact of unsystematic risk. If our investment is distributed across various asset classes the impact of unsystematic risk is reduced.
If we have placed fixed deposit in several banks, then even if one of the bank goes bankrupt our entire fixed deposit investment is not lost.
Similarly if our equity investment is in Tata Motors, HLL, Infosys, adverse news about Infosys will only impact investment in Infosys, all other stocks will not have any impact.
To reduce the impact of systematic risk, we should invest regularly. By investing regularly we average out the impact of risk.
Mutual fund, as an investment vehicle gives us benefit of both diversification and averaging.
Portfolio of mutual funds consist of multiple securities and hence adverse news about single security will have nominal impact on overall portfolio.
By systematically investing in mutual fund we get benefit of rupee cost averaging.
Mutual fund as an investment vehicle helps reduce, both, systematic as well as unsystematic risk.
For more on mutual funds, click here.
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