Final answer:
Total risk includes all uncertainties in an investment, while systematic risk is the market-wide risk that cannot be diversified away. Portfolio construction leverages diversification to mitigate unsystematic risk, aligning with an investor's risk tolerance.
Step-by-step explanation:
Understanding the differences between total risk and systematic risk is fundamental when constructing investment portfolios. Total risk encompasses all the uncertainties associated with an investment, including both systematic risk and unsystematic risk. Systematic risk, also known as market risk, is the portion of total risk that is inherent to the entire market or market segment and cannot be eliminated through diversification. Unsystematic risk, on the other hand, is specific to a particular company or industry and can be mitigated through diversification.
When constructing portfolios, investors can manage these risks to align with their individual risk tolerance. By diversifying investments across various asset classes, industries, and geographic locations, unsystematic risk can be reduced. However, since systematic risk affects the entire market, it cannot be diversified away, and investors must decide how much of this risk they are willing to accept based on their investment goals and time frames.