Systematic Vs Unsystematic Risk: The Key Differences

In financial jargon, the term “unsystematic” refers to a quality that is not commonly shared among many investment opportunities. This is distinct from systematic risk, the dangers inherent to the market as a whole. This research confirmed earlier advice from Benjamin Graham in his 1949 book, The Intelligent Investor. If you want to know how much systematic risk a particular security, fund, or portfolio has, you can look at its beta, which measures how volatile that investment is compared to the overall market. A beta of greater than one means the investment has more systematic risk (i.e., higher volatility) than the market, while less than one means less systematic risk (i.e., lower volatility) than the market.

While investors may be able to anticipate some sources of unsystematic risk, it is nearly impossible to be aware of all risks. Unsystematic risk may be significantly reduced through diversification so that systematic risk is all that remains in a portfolio. For a well-diversified portfolio, the unsystematic risk may be negligible. Unsystematic risk can be calculated by subtracting the market risk, or systematic risk, from the total risk.

Systematic risk is often calculated with beta, which measures the volatility of a stock or portfolio relative to the entire market. Meanwhile, company risk is a bit more difficult to measure or calculate. Used judiciously, these techniques can mitigate the impact of systematic risk.

Effectively managing portfolio risk requires addressing both systematic and unsystematic risks. While systematic risk cannot be avoided, investors can hedge these risks through assets like gold, Treasuries, etc. Diversifying across unrelated assets, sectors, geographies, etc. remains key to minimizing exposure to unsystematic risks. A key first step is for advisors to thoroughly assess each client’s risk tolerance based on their investment timeline, income needs, and emotional ability to withstand market volatility. Advisors can then recommend appropriate asset allocations across stocks, bonds, cash, and other securities to align with an investor’s financial goals and comfort with risk. More conservative investors may favor a higher allocation to fixed-income assets, while more aggressive investors may tolerate more equities exposure.

Systematic vs Unsystematic Risk CFA Level I Portfolio Management

Systematic, in this context, refers to the economic, political, and sociological factors that impact all securities to varying degrees. However, systematic risk incorporates interest rate changes, inflation, recessions, and wars, among other major changes. Shifts in these domains can affect the entire market and cannot be mitigated by changing positions within a portfolio of public equities. Systematic risk, also known as undiversifiable risk, volatility risk, or market risk, affects the overall market, not just a particular stock or industry. Because of the far-reaching scope of systematic risk – wherein the entire economy and financial markets are placed in a position of vulnerability – portfolio diversification is incapable of mitigating it.

Company-Specific Risks

1. When the Fed raises interest rates, some companies balance sheets may be stuck with lower-yielding investments.
2. Unsystematic risk is the risk that is unique to a specific company or industry.
3. The key difference is that investors can minimize unsystematic risk via diversification across assets, sectors, and geographies.
4. If one part of the market is doing poorly, the other investments can help offset the losses.
5. These changes can increase operational costs or introduce legal hurdles.
6. Moreover, investors should be able to diversify away unsystematic risks by strategically targeting a wide enough range of holdings in their respective portfolios.

Operational risks can result from unforeseen or negligent events, such as a breakdown in the supply chain or a critical error being overlooked in the manufacturing process. A security breach could expose confidential information about customers or other types of key proprietary data to criminals. For example, management failing to take out a patent to protect unsystematic risk is also known as a new product would be an internal risk, as it may result in the loss of competitive advantage. Futures trading involves the substantial risk of loss and is not suitable for all investors. One example of this is a company that manufactures and sells household appliances.

Systematic risk affects the entire market, while unsystematic risk is specific to a particular company or industry. Both risk types impact investors, but they’re usually managed differently. Investors can reduce unsystematic risk by holding a diversified portfolio instead of investing in individual stocks.

Unsystematic Risk Scenarios in Individual Investments

In contrast, if a specific tech company experiences management issues leading to plummeting stock prices, it illustrates unsystematic risk. Unsystematic risk, also known as specific or diversifiable risk, plays a crucial role in the field of finance and investment. This type of risk is unique to a particular company or industry, in contrast to market or systematic risk that affects all companies. On the other hand, systematic risk is the risk that affects the entire market or a broad market segment. Common sources of systematic risk include interest rates, inflation, political uncertainty, and widespread natural disasters. Systematic risk is non-diversifiable because such risk factors affect the market as a whole.

For example, if a portfolio is balanced and diversified, and a stock declined because of the company’s bad earnings, the rest of the assets should not be affected by the issues of one specific company. Setting asset allocation ranges rather than fixed targets also provides flexibility to adjust allocations in response to signals about the market cycle. You can broadly categorize unsystematic risk either as business or financial. The preceding bullet points provide an expansion of these two categories. Another potential risk might be Tesla’s CEO, Elon Musk, who has cultivated a reputation as an eccentric and unpredictable genius.

1. The total risk for investments is unsystematic risk plus systematic risk.
2. They would be vulnerable if airline industry employees went on strike, for example.
3. A beta equal to one means the investment carries the same systematic risk as the market.
4. That is why it is also known as contingent risk, unplanned risk or risk events.
5. In many contexts, events like earthquakes, epidemics and major weather catastrophes pose aggregate risks that affect not only the distribution but also the total amount of resources.

Systematic risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy. There are five types of unsystematic risk—business, financial, operational, strategic, and legal/regulatory risk. Systematic risk is risk that is inherent to the entire market or market segment. It is the risk that is not specific to any one company or investment and cannot be diversified away. To manage risk successfully, it’s important to understand the different types of risks that investors face.

For example, if an investor has placed too much emphasis on cybersecurity stocks, it is possible to diversify by investing in a range of stocks in other sectors, such as healthcare and infrastructure. The notable characteristic of unsystematic risk is the fact that the risk can be mitigated through portfolio diversification, i.e. the strategic inclusion of uncorrelated assets in a portfolio. Unsystematic risk arises from company or industry-specific factors with a disproportional impact on a specific security (or securities with commonalities). In corporate finance, unsystematic risk is defined as the risk that pertains specifically to individual securities or a particular industry. Examples of systematic risk include economic recessions, inflation, wars, terrorism, natural disasters, and changes in interest rates.

This certainly spurs us on to produce more materials to ease the burden of CFA candidates worldwide. For those of you who are new to Udemy, it is the world’s largest marketplace for online courses. We have an irresistible offer for you to upgrade to our Level I Premium Membership, where you will gain full access to ALL 10 topical courses under the CFA Level I curriculum. He has a wide range of interests in all things related to tech, from web development to e-learning, gadgets to apps. Keith loves exploring different cultures and the untouched gems around the world. He currently lives in Singapore but frequently travels to share his knowledge and expertise with others.

In the context of an investment portfolio, unsystematic risk can be reduced through diversification—while systematic risk is the risk that’s inherent in the market. Systematic risk is often out of an investor’s control since it’s based on factors like the political and economic environment. To manage systematic risk, investors typically diversify their portfolios by investing in different asset classes. If one part of the market is doing poorly, the other investments can help offset the losses. It is the portion of total risk that is unique to a firm, industry, or property.