Systematic risk and unsystematic risk are two different types of risks that investors face when investing in financial markets. Here’s an overview of the differences between the two:
- Systematic Risk:
Systematic risk, also known as market risk or non-diversifiable risk, refers to the risk factors that affect the overall market or entire segments of the market. These risks are beyond the control of individual investors and are inherent to the economic, political, and macroeconomic conditions. Systematic risk cannot be eliminated through diversification because it affects the entire market.
Examples of systematic risk factors include:
- Economic Factors: Economic recessions, inflation, interest rate changes, changes in GDP growth, and fluctuations in exchange rates.
- Political and Regulatory Factors: Changes in government policies, political instability, trade disputes, and geopolitical tensions.
- Market Factors: Stock market crashes, changes in investor sentiment, and changes in market liquidity.
Investors are exposed to systematic risk regardless of the specific investments they hold. It affects the overall returns of the market or a particular segment of the market. Systematic risk is typically addressed through asset allocation strategies, where investors diversify their portfolios across different asset classes (such as stocks, bonds, and cash) to reduce exposure to specific systematic risks.
- Unsystematic Risk:
Unsystematic risk, also known as specific risk, idiosyncratic risk, or diversifiable risk, refers to risks that are specific to individual companies, sectors, or assets. These risks are unique to a particular investment and are not related to broader market factors. Unsystematic risk can be reduced or eliminated through diversification.
Examples of unsystematic risk factors include:
- Company-Specific Factors: Poor management, product recalls, labor strikes, legal issues, or changes in competitive landscape.
- Industry-Specific Factors: Technological disruptions, regulatory changes specific to an industry, or changes in consumer preferences.
- Financial Factors: Credit risk, default risk, or changes in the financial health of a specific company.
By diversifying their portfolios across different companies, sectors, or asset classes, investors can reduce unsystematic risk. As the number of investments in a portfolio increases, the impact of unsystematic risk on the overall portfolio decreases.
It’s important to note that while unsystematic risk can be reduced through diversification, systematic risk cannot be eliminated. Systematic risk affects the entire market and requires a different approach, such as managing exposure through asset allocation or hedging strategies.
Understanding the distinction between systematic and unsystematic risk is valuable for investors as it helps them assess and manage different types of risks associated with their investment1 portfolios. By diversifying and considering both systematic and unsystematic risks, investors can aim to achieve a better balance between risk and potential returns.
