Risk

Risk in holding securities is associated with the possibility that realized returns will be less than the returns that were expected. Forces that contribute to variations in return constitute elements of risk. Some influences are external to the firm, cannot be controlled and affect large numbers of securities. Other influences are internal to the firm and are controllable to a larger degree. Those forces that are uncontrollable, external, and broad in their effect are called sources of systematic risk. Conversely, controllable, internal factors somewhat peculiar to industries or firms are referred to as sources of unsystematic risk.

Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks and bonds to move together in the same manner. For example, if the economy is moving toward a recession and corporate profits shift downwards, stock prices may decline across a broad front. Nearly all stocks listed on the stock exchange move in the same direction as the index.

Unsystematic risk is the portion of total risk that is unique to a firm or industry. Factors such as management capability, consumer preferences, and labour strikes are some of the examples of unsystematic risk. Unsystematic factors are largely independent of factors affecting securities markets in general.