There are two broad categories of financial
risk.
Systematic risk,
sometimes called market risk, is characteristic
of an entire market or an entire asset class at any given time.
The stock market's volatility is one example of systematic
risk, as is the inverse relationship between a bond's price
and its
yield.
Systematic risk also applies to the recurrent, though unpredictable,
pattern of strength and weakness in one asset class moving in
a reciprocal pattern to a different asset class.
Nonsystematic risk, on the other hand, is inherent in an individual
security or portfolio of securities. This type of risk stems from
company- and market-specific factors such as management decisions,
the emergence of new technologies, or the development of competitive
products that could undercut the company's value and the
stock's price.
Defensive maneuvers
Because you can anticipate systematic risk, you can take precautions
to protect your portfolio against its effects. By allocating some
of your assets to stocks and others to fixed-income investments,
for example, you can frequently use the strong returns in one
category of investments to offset weak returns in the other. Similarly,
you might concentrate on stocks for your long-term goals and less
volatile bonds or cash equivalents for your short-term needs.
There are also defenses against nonsystematic risk. For example,
if you diversify within an asset class (such as stocks), or among
the subclasses or
sectors of that class (such as stocks in a small technology company or
large manufacturing company), you may be able to counter the impact
of bad management decisions in one corporation by profiting from
another's successful new invention.
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates
Tom Dorsey of Dorsey, Wright & Associates explains how
to manage nonsystematic risk.
One way to solve the problem of nonsystematic risk is to
buy a package of stocks within a particular sector you like. You might
choose two or three names in the group, or buy a package of stocks offered
through
SPDRs
(pronounced Spiders), NASDAQ 100 shares, Select Sector SPDRs, Sector Holders,
or Shares. These exchange traded trusts are a way to invest in a sector
without having to pick just one stock.
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates 