What is systematic risk versus unsystematic risk?

When it comes to investing in the stock market or any financial asset, understanding the types of risks involved is crucial for making informed decisions. Two main types of risks are systematically distinguished: **systematic risk** and **unsystematic risk**. These two risks have distinct characteristics and impact investments in different ways. Let’s explore these concepts in detail so you can gain a better understanding of how they affect your investments.

1. What is Systematic Risk?

Systematic risk, also known as **market risk** or **non-diversifiable risk**, refers to the risk that affects the entire market or a broad segment of the market. This type of risk cannot be eliminated through diversification, as it impacts almost all assets within a market. Factors contributing to systematic risk include economic changes, interest rate fluctuations, inflation, geopolitical events, and natural disasters. Since these events influence the overall market, all assets are generally affected to some extent.

For example, a recession that leads to a broad market downturn is a systematic risk that will likely affect the stock prices of most companies, regardless of their specific industries. Similarly, a rise in interest rates can negatively impact the value of stocks, bonds, and other investments across the board.

2. What is Unsystematic Risk?

Unsystematic risk, also known as **specific risk** or **diversifiable risk**, is the risk that is specific to a particular company or industry. Unlike systematic risk, unsystematic risk can be reduced or eliminated through diversification. This risk is related to factors such as management changes, product recalls, labor strikes, regulatory changes, or other events that are specific to a single company or a small group of companies.

For example, if a tech company faces a scandal or a major product failure, its stock may plummet, but the overall stock market might remain unaffected. Similarly, if a company faces a lawsuit or its CEO resigns, these events will only impact that particular company, not the entire market.

3. Key Differences Between Systematic and Unsystematic Risk

While both systematic and unsystematic risks affect investments, the key differences are as follows:

• Impact: Systematic risk affects the entire market, whereas unsystematic risk impacts individual companies or industries.
• Diversification: Systematic risk cannot be eliminated through diversification, but unsystematic risk can be reduced by holding a diversified portfolio of investments.
• Control: Investors have no control over systematic risk, as it is influenced by macroeconomic factors, but they can manage unsystematic risk by choosing investments carefully and diversifying.
• Examples: Systematic risks include recessions, inflation, interest rate changes, and wars. Unsystematic risks include company-specific events like a management change, a product launch failure, or a lawsuit.

4. Managing Systematic and Unsystematic Risk

Managing risks is an essential part of investing. Here’s how you can handle both systematic and unsystematic risks:

• For Systematic Risk: Although it cannot be eliminated, you can manage systematic risk by staying informed about the economic environment, adjusting your asset allocation, and using hedging strategies such as options and futures to protect your portfolio from major market fluctuations.
• For Unsystematic Risk: Diversification is your best strategy. By investing in a variety of assets across different sectors, you reduce the impact of any negative events affecting a single company or industry. Additionally, conducting thorough research before making an investment can help identify companies with lower unsystematic risks.

5. Conclusion

In conclusion, understanding the difference between systematic and unsystematic risks is vital for any investor. While systematic risk affects the broader market and cannot be avoided, unsystematic risk is specific to individual companies or industries and can be minimized through diversification. By implementing sound strategies to manage both types of risk, you can build a more resilient portfolio and improve your chances of long-term investment success.