Systematic risk is the risk tied to the broader market, while unsystematic risk is a risk specific to a company or industry.
Understanding the different types of risk is crucial for investors looking to manage their portfolios effectively. Risks in investing can generally be categorized into two main types: systematic risk and unsystematic risk.
Understanding Systematic Risk
Systematic risk, also known as market risk, is the inherent risk associated with the overall market or the entire economic system. As the reference states, systematic risk is the risk tied to the broader market and is attributed to broad market factors. It affects a wide range of investments simultaneously and cannot be eliminated through diversification within a single market.
Systematic risk represents the investment portfolio risk that is not based on individual investments. It is caused by factors like:
- Changes in interest rates
- Inflation
- Recessions
- Political instability
- Natural disasters impacting the economy
These factors are external to any specific company or industry and affect the entire market.
Understanding Unsystematic Risk
In contrast, unsystematic risk is specific to a particular company, industry, or asset. The reference defines unsystematic risk as a risk specific to a company or industry. This type of risk is not correlated with the overall market and can potentially be reduced through diversification.
Unsystematic risk arises from issues related to:
- Management decisions
- Labor strikes
- Product recalls
- Changes in industry regulations
- Company-specific lawsuits
These events typically impact only the specific company or a limited set of companies within an industry, not the entire market.
Key Differences Between Systematic and Unsystematic Risk
The primary difference lies in their source and how they can be managed:
| Feature | Systematic Risk | Unsystematic Risk |
|---|---|---|
| Source | Broad market factors, economy-wide | Company or industry-specific factors |
| Affects | Wide range of investments/entire market | Specific company or industry |
| Manageable? | Cannot be eliminated through diversification | Can be reduced through diversification |
| Also Known As | Market Risk | Specific Risk, Idiosyncratic Risk |
Managing Risk in Your Portfolio
- Systematic Risk: Since systematic risk affects the entire market, it cannot be eliminated by simply holding a diverse set of stocks within the same market. Investors might use strategies like asset allocation across different asset classes (e.g., stocks, bonds, real estate) or hedging techniques to potentially mitigate some market risk exposure.
- Unsystematic Risk: Unsystematic risk is often referred to as diversifiable risk. By investing in a variety of companies across different industries and geographical locations, an investor can significantly reduce the impact of a negative event affecting a single company or sector on their overall portfolio.
In summary, understanding both systematic and unsystematic risk helps investors build more resilient portfolios and make informed decisions about diversification and risk management strategies.
