Systematic and unsystematic risks are two critical concepts that every investor must understand to navigate the complexities of financial markets effectively. Systematic risk, or market risk, impacts the entire economy and is influenced by external factors like inflation, interest rate changes, or geopolitical events, making it unavoidable through diversification. In contrast, unsystematic risk arises from internal factors specific to a company or industry, such as management decisions or product performance, and can be mitigated by diversifying investments. By comprehending the scope and implications of these risks, investors can make informed decisions to safeguard their portfolios against potential losses.
In this article, we will explore the meanings of systematic and unsystematic risks, their key differences, and whether systematic or unsystematic risk management is more effective for investors.
What is a systematic risk?
Systematic risk affects the entire financial system or stock market and leads to widespread impacts across the economy. This type of risk is inherent to the market as a whole and cannot be eliminated through diversification. It arises from external factors such as:
- Political instability
- Governmental changes and political events can lead to market volatility and uncertainty.
- Economic crises and recessions
- Usually, broad economic downturns impact all sectors.
- They cause significant market declines.
- Changes in taxation laws
- New tax policies affect overall market performance.
- They influence business operations and consumer spending.
- Natural disasters
- Events like earthquakes or hurricanes disrupt markets and economies.
- They lead to widespread financial instability.
Let us understand this better through an example:
When the COVID-19 pandemic hit in 2020, it led to a nationwide lockdown, severely disrupting economic activities across all sectors. The stock market experienced significant volatility. All major indices like the BSE Sensex and NSE Nifty plummeted. This market-wide downturn affected nearly all investments, irrespective of the industry.
This event clearly shows how external, uncontrollable factors like a global health crisis can create systematic risk and impact the entire financial system and market.
What is an unsystematic risk?
Unsystematic risk is the threat associated with a specific company or industry rather than the overall market. This type of risk arises from factors that can affect individual securities or portfolios of securities. Some common causes of this risk are:
- Regulatory changes impacting a particular industry
- The entry of new competitors
- Product recalls
- A company getting exposed for fraudulent activities
- Labour strikes, and more.
Let us understand the impact of unsystematic risk better through an example:
Say a pharmaceutical company faces a sudden regulatory setback due to new government regulations impacting its ability to market a particular drug. Now, it must be noted that this regulatory change is specific to the pharmaceutical industry and affects only companies operating in that sector rather than the entire market.
To mitigate unsystematic risk, most investors prefer “diversification”. By spreading investments across different sectors, investors try to reduce the impact of adverse events affecting a single industry or company.
Systematic risk vs. Unsystematic risk – A comparison table
Parameters |
Systematic risk |
Unsystematic risk |
What does it mean? |
The risk associated with the entire market as a whole |
Risk specific to a particular company or industry |
What is the quantum of impact? |
Affects a large number of securities across the market |
Affects specific securities or a particular industry |
Can you control it? |
No, it cannot be controlled |
Yes, through diversification |
How to manage the risk? |
Managed through hedging and asset allocation |
Managed through diversification of the investment portfolio |
What are some common types? |
|
|
Can you avoid it? |
No, you cannot avoid systematic risk |
Yes, it can be avoided by making strategic investment choices |
Systematic Risk vs Unsystematic Risk - Key Differences Summarised
Systematic risk and unsystematic risk are two fundamental types of investment risks. Here's a breakdown of their key differences:
- Systematic risk impacts the entire market; unsystematic risk affects specific companies or industries.
- Systematic risk cannot be mitigated by diversification; unsystematic risk can be reduced.
- Examples of systematic risk includes market crashes, inflation, interest rate hikes. Examples of unsystematic risk includes product recalls, poor management, sector downturns.
- Systematic risks are more challenging to predict; unsystematic risks can be anticipated with company research.
- Systematic risks are macroeconomic; unsystematic risks are microeconomic.
- Investors cannot control systematic risks but can control unsystematic risks.
- Systematic risks affect all investments; unsystematic risks affect only specific investments.
- Systematic is external risk; unsystematic is internal risk.
- Both types of risk are crucial in investment planning.
Differences between systematic risk and unsystematic risk with an example
It is worth mentioning that investors who are aware of the key differences between these risks often safeguard and optimise their portfolios effectively. This way, they enhance their portfolio’s performance and resilience. Let us differentiate systematic and unsystematic risks in detail:
Systematic risk affects the entire market and is influenced by external factors such as economic changes, political events, and natural disasters. Some common examples of these risks are:
- Changes in central bank interest rates affecting the valuation of all securities.
- A stock market crash leading to a widespread decline in asset values.
- Fluctuations in currency exchange rates impacting companies involved in international trade.
- Political instability, such as war or policy changes, affecting market performance.
It is worth mentioning that systematic risk cannot be eliminated through diversification. However, we can still manage it through strategies such as asset allocation, hedging, and investing in non-correlated assets.
Now, when we talk about unsystematic risk, it is specific to a particular company or industry. It arises from internal factors such as management decisions, financial practices, and competitive dynamics. Some common examples include:
- A strike at a company's manufacturing plant halting production and impacting its stock price.
- A company's exposure to credit risk affects its financial stability.
- Changes in industry regulations impacting specific companies.
- A company recalls its products, significantly affecting its performance.
Unlike systematic risks, which cannot be mitigated, unsystematic risks can be mitigated through diversification. By holding a variety of assets across different industries, investors can reduce the impact of any single company's poor performance.
Let us understand this distinction better through some hypothetical examples:
Example of systematic risk
- Say an investor, Mr. A, has a portfolio with a beta of 2.0.
- Now, if the market rises by 3%, his portfolio is expected to rise by 6%,
- Whereas, if the market falls by 3%, his portfolio is expected to fall by 6%.
- To mitigate this risk, Mr. A:
- Reduces his exposure to stocks
and - Increases his holdings in less volatile bonds.
- Reduces his exposure to stocks
Example of unsystematic risk
- Mr. A invests in a diversified portfolio, including airline stocks.
- When an airline company faces a strike, the value of his airline stocks drops.
- To manage this risk, he sells his airline stocks and invests in more stable sectors or bonds.
Advantages of Systematic Risk
While systematic risk is generally perceived as a downside, there are certain advantages for investors who understand and manage it effectively. Here are the key benefits:
- Market predictability: Systematic risks like inflation or interest rate changes often develop slowly, giving investors time to adjust their portfolios accordingly.
- Broad economic indicators: These risks provide valuable insights into the overall health of the economy, helping investors make informed decisions.
- Long-term growth opportunities: For patient investors, market downturns driven by systematic risks can present buying opportunities, leading to long-term gains.
- Encourages portfolio diversification: Systematic risk highlights the need for a well-diversified portfolio across various asset classes and markets.
- Enhanced risk management: Understanding systematic risks encourages investors to implement strategies like hedging to protect their investments.
- Policy influence: Governments and central banks often respond to systematic risks with policies that can stabilize markets, benefiting long-term investors.
- Global perspective: Systematic risks provide a macro view, helping investors gauge global market trends and adjust their international exposure.
- Learning opportunities: Managing systematic risk teaches investors to adapt to market conditions and refine their strategies.
- Emphasizes the importance of resilience: Investors are pushed to build stronger, more resilient portfolios in response to systematic challenges.
- Better risk-reward balance: Awareness of systematic risk helps investors weigh potential risks against expected returns for better decision-making.
Disadvantages of Systematic Risk
Systematic risk, while an inherent part of investing, poses several challenges and disadvantages that investors must navigate. Here are the key drawbacks:
- Non-diversifiable: Unlike unsystematic risk, systematic risk cannot be eliminated through diversification, affecting all investments.
- Market volatility: Systematic risks contribute to overall market volatility, leading to fluctuating investment values.
- Unpredictability: Economic factors influencing systematic risk, such as geopolitical events or global financial crises, can be difficult to predict and manage.
- Potential for large losses: Systematic risks can lead to significant financial losses, especially during economic downturns or market crashes.
- Investment uncertainty: The impact of systematic risks can introduce uncertainty, making it challenging to forecast future investment returns accurately.
- Economic sensitivity: Investments are highly sensitive to macroeconomic changes, such as interest rates or inflation, which can affect performance.
- Impact on portfolio performance: Systematic risk affects the performance of entire markets or sectors, potentially leading to broad declines in portfolio value.
- Regulatory changes: Systematic risks often lead to regulatory changes that can alter market dynamics and impact investment strategies.
- Stress on investors: Prolonged periods of systematic risk can cause stress and anxiety for investors as they navigate turbulent market conditions.
- Limited control: Investors have limited ability to control or mitigate systematic risks, making it challenging to manage their overall exposure.
Types of systematic risks
Systematic risks come in various forms that can significantly impact investments. Below are a few key types:
- Interest rate risk: This risk stems from fluctuations in market interest rates, particularly affecting fixed-income securities such as bonds and asset-backed investments. Since the yield on these securities moves inversely with interest rates, a rise in interest rates often leads investors to withdraw their funds from fixed-income instruments in favour of higher-yielding opportunities.
- Market risk: Market risk arises from the collective behaviour of investors reacting to market conditions. During periods of financial instability, even top-performing companies may see reduced investment due to widespread market pessimism.
- Purchasing power risk: Also known as inflation risk, this type of risk is linked to the erosion of money’s purchasing power due to inflation. For instance, with an inflation rate of 5% annually, an item costing Rs. 830 today would cost Rs. 871.50 a year later, reducing the value of money over time.
Advantages of Unsystematic Risk
Unsystematic risk, while often viewed negatively, has several advantages that can benefit investors when managed properly. Here are the key benefits:
- Diversification potential: Unsystematic risk can be mitigated through diversification, allowing investors to spread risk across various assets and reduce overall portfolio volatility.
- Selective investment: Investors can choose specific stocks or sectors based on research, potentially enhancing returns by avoiding high-risk investments.
- Active management: Unsystematic risk allows for active portfolio management, where investors can adjust holdings based on company-specific developments or industry trends.
- Opportunity for alpha: Skilled investors can capitalize on unsystematic risk by identifying undervalued or high-potential stocks, potentially achieving above-market returns.
- Company-specific strategies: Investors can tailor strategies to address unsystematic risks, such as focusing on strong management teams or innovative companies.
- Market insights: Exposure to unsystematic risk provides insights into specific industries and companies, aiding in better investment decision-making.
- Risk adjustment: Investors can adjust their portfolios based on their risk tolerance, allowing for personalized risk management.
- Potential for high returns: Successfully managing unsystematic risk can lead to significant gains, particularly in high-growth sectors or emerging markets.
- Impact of research: Detailed analysis and research can help mitigate unsystematic risk, leading to informed investment choices and potentially lower risk.
- Flexibility: Investors have more control over unsystematic risk compared to systematic risk, enabling them to react to and manage specific challenges effectively.
Disadvantages of Unsystematic Risk
Unsystematic risk, while manageable to some extent, has several drawbacks that can impact investors. Here are the key disadvantages:
- Limited diversification: Even with diversification, unsystematic risk can still affect a significant portion of a portfolio if it’s concentrated in a particular sector or stock.
- Company-specific issues: Factors like management changes or product failures can negatively impact individual investments, leading to potential losses.
- Research intensity: Managing unsystematic risk requires extensive research and analysis, which can be time-consuming and resource-intensive.
- Potential for high volatility: Companies or industries with high unsystematic risk may experience significant price swings, affecting portfolio stability.
- Less predictability: Unsystematic risks related to specific companies or sectors can be difficult to predict, leading to unexpected investment outcomes.
- Higher risk concentration: Investing heavily in a few stocks or sectors increases exposure to unsystematic risk, potentially leading to larger losses.
- Impact on smaller portfolios: Smaller portfolios may be more affected by unsystematic risk due to less diversification.
- Sector cyclicality: Industries with high unsystematic risk may be subject to cycles, causing periods of poor performance.
- Need for active management: Effective management of unsystematic risk often requires continuous monitoring and adjustments, demanding active involvement.
- Investment inefficiencies: High unsystematic risk can lead to inefficiencies in investment performance, requiring careful strategy to mitigate potential losses.
Types of unsystematic risks
Unsystematic risks can be broadly categorised into two types:
- Business risk: This type of risk arises from internal factors that influence a company's performance and revenue. It can also be caused by external, company-specific events, such as regulatory actions. For example, if a government bans a raw material essential to a company's operations, it could significantly impact the business.
- Financial risk: Financial risk pertains to a company's capital structure, particularly its use of debt and equity. Excessive borrowing can negatively affect the debt-to-equity ratio, signalling financial instability. A poor debt-to-equity ratio might even indicate that the company is at risk of bankruptcy.
How are systematic risk and unsystematic risks measured?
Systematic risk is measured by using metrics such as “beta”. It reflects how sensitive a portfolio is to market fluctuations. Investors should understand that a beta above 1 signifies that the investment is more volatile than the market, while a beta below 1 indicates it is less volatile.
Some other measures include the Capital Asset Pricing Model (CAPM), which calculates expected returns based on systematic risk.
On the other hand, unsystematic risk is measured through fundamental analysis, which assesses the financial health and operational aspects of a specific company. Several tools used to analyse a portfolio's total risk (which includes the unsystematic component) are:
- Variance
- Standard deviation
- Sharpe ratio
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Are systematic risks and unsystematic risks diversifiable?
Systematic risk is not diversifiable. That’s because it affects the entire market or a broad segment and originates from external factors like economic changes and political events. Thus, it impacts all investments to some degree, which makes it impossible to eliminate through diversification.
On the other hand, unsystematic risk is diversifiable. It is specific to individual companies or industries. By holding a diversified portfolio across various sectors, investors can significantly reduce or eliminate unsystematic risk. This happens because diversification spreads the risk and allows the negative performance of one asset to be offset by the positive performance of others.
Is business risk systematic or unsystematic?
Risks in the investment landscape are broadly divided into systematic risks and unsystematic risks, depending on their scope and impact. Understanding the distinction is crucial for effective risk management.
Systematic risk
Systematic risk, also referred to as "market risk," affects the entire economy or market and cannot be avoided through diversification. It arises from macroeconomic factors beyond the control of individual companies, such as:
- Interest rate risk: Rising interest rates can slow economic activity, making borrowing costlier and reducing stock valuations.
- Inflation risk: Higher inflation erodes purchasing power, lowers consumer spending, and impacts business profitability.
- Recession risk: Economic downturns result in reduced demand for goods and services, leading to lower revenue for businesses across the board.
Since companies cannot directly influence these external factors, mitigating systematic risk involves strategies like holding diversified portfolios and investing in assets like gold or government bonds, which typically perform better during economic uncertainties.
Unsystematic risk
Unsystematic risks are specific to individual companies or industries and arise from factors such as:
- Operational challenges: Disruptions in the supply chain or production processes.
- Legal issues: Exposure to lawsuits or regulatory penalties.
- Management decisions: Poor leadership or ineffective strategies.
- Market competition: Losing market share to more competitive players.
Unlike systematic risk, unsystematic risk can be reduced through diversification. By spreading investments across various companies and sectors, investors minimise the impact of any one entity's failure. Strong internal controls, contingency planning, and innovation can also help businesses address company-specific uncertainties.
Key takeaway
Systematic risk influences the entire market and is largely unavoidable, while unsystematic risk is tied to specific companies or industries and can be mitigated. A balanced portfolio that combines diversified assets with proactive risk management strategies is essential to safeguarding investments against both types of risk.
Systematic and Unsystematic Risks - Impact on different asset classes
Systematic and unsystematic risks influence various asset classes differently, affecting their returns and stability. Understanding these impacts helps investors make informed decisions and develop strategies to manage their portfolios effectively. Each asset class responds uniquely to these risks, shaped by its inherent characteristics and market conditions.
1. Stocks
Systematic risk affects stocks significantly as broader market movements impact their performance. Factors like economic downturns, interest rate changes, and geopolitical events can cause widespread stock market volatility. Conversely, unsystematic risk is more specific to individual companies or sectors, such as poor management decisions or sector-specific downturns. Diversification within stocks can mitigate unsystematic risk, but systematic risk remains a challenge.
2. Bonds
Bonds are influenced by systematic risk primarily through interest rate changes and economic conditions. When interest rates rise, bond prices typically fall, impacting their returns. Unsystematic risk in bonds relates to the creditworthiness of issuers. Corporate bonds face higher unsystematic risk compared to government bonds, which are generally considered safer. Effective bond portfolio management requires balancing these risks.
3. Real estate
Real estate investments are affected by both systematic and unsystematic risks. Systematic risks, such as economic recessions, can lead to declines in property values and rental income. Unsystematic risks include property-specific issues like maintenance problems or local market conditions. Diversifying real estate investments across different locations and property types can help manage unsystematic risk.
4. Other asset classes
Other asset classes, such as commodities, cryptocurrencies, and collectibles, also face systematic and unsystematic risks. Commodities are sensitive to global economic conditions and geopolitical events, while cryptocurrencies can be highly volatile due to market speculation. Collectibles, like art and antiques, are influenced by trends and individual market demand. Each asset class requires a tailored approach to risk management based on its unique characteristics.
Similarities between systematic risk and unsystematic risk
Despite being different from each other, both systematic and unsystematic risks significantly affect the value of an investment portfolio. Let us check out some similarities between them:
- To assess their impact on a portfolio, both risks are measured using statistical tools such as:
- Beta
- Standard deviation
- Variance
- Both systematic and unsystematic risks influence the expected returns of investments.
- Both require strategic risk management practices. While diversification primarily addresses unsystematic risk, systematic risk is managed through:
- Asset allocation
and - Hedging
- Asset allocation
- Furthermore, several financial models and analyses, such as the Capital Asset Pricing Model (CAPM), consider both these risks to estimate expected returns and assess overall risk exposure.
How to invest while considering systematic risk vs. unsystematic risk?
Understanding the risks you face is key to managing them effectively. The best way to protect against systematic risk is through asset allocation. This means deciding how much of your portfolio goes into different types of investments.
For example,
- Say you put 70% into stocks and the remaining 30% into:
- Bonds
- Cash
- Real estate
- This mix cushions your portfolio against broad market downturns.
However, remember that your ideal asset allocation depends on factors like your age, risk tolerance, and financial goals.
In contrast, diversification is key to managing unsystematic risk. A diversified portfolio spreads investments across various assets to balance risk. Instead of putting all your money into one or two companies, consider investing in mutual funds or ETFs. These options offer exposure to a wider range of stocks and sectors and reduce the impact of any single investment’s poor performance.
Key takeaways
- Systematic risk impacts the entire market, a specific segment, or an industry.
- It is a common aspect of investing in the stock market and is influenced by factors like inflation and interest rates.
- To manage systematic risks, investors can use strategies like hedging and asset allocation.
- Unsystematic risk affects only a particular security or investment. Factors such as a company’s financial health or new competitors can influence this risk.
- Investors can reduce unsystematic risk through diversification, i.e., by spreading investments across different assets and sectors.
Conclusion
Investors who understand systematic and unsystematic risks often develop a balanced approach to investing and better manage their portfolios. It must be noted that systematic risk affects the entire market and cannot be eliminated through diversification. Instead, most investors manage it through strategies like asset allocation and hedging.
On the other hand, unsystematic risk is specific to individual companies or industries. It can be minimised by diversifying investments across various sectors. Both these risks impact investment returns and require strategic management.
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