4.4.2. Types of Investment Risk
Risk is a critical factor when assessing the performance of a security and the construction of a portfolio. In the context of investing, risk is defined as the volatility of the returns of a security or a portfolio. When volatility is high, returns can vary from high to low, so investors expose themselves to the possibility of bigger losses and bigger gains.
A portfolio of securities is composed of both systematic and unsystematic risk.
Systematic risk is the risk that the whole bond market will drop (market risk, inflation risk), causing a drop in the performance of the entire portfolio.
Nonsystematic risk, also called unsystematic risk, is the risk that the value of a specific security within the portfolio will decline due to factors peculiar to the issuing municipality or the sector of the bond.
Investors generally expect the price of the bond to account for systematic risk, because this risk is general to the market and cannot be diversified. Investors can reduce unsystematic risk by holding a variety of uncorrelated securities in an investment portfolio. A diversified portfolio is less risky regarding unsystematic risk, because the volatility in each security is unlikely to move in the same direction or degree at the same time as the others. Thus, investors expect to be compensated for systematic risk, which they have little control over, but not compensated for nonsystematic risk, which is in their control.
Types of systematic risk include:
• Market Risk. When the bond market declines as a whole, it drags down the value of individual securities, regardless of their fundamental characteristics. An overheated economy could inflate interest rates, causing bond prices to decline. A financial crisis could depress economic performance, causing companies to default on their debt and the bond market to crash. Market risk is considered systematic risk because it cannot be lessened through a diverse portfolio of