What Are Unsystematic and Systematic Risks?

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What Are Unsystematic and Systematic Risks?

All investments are subject to risk. It is generally believed that investors are rewarded for taking risk. However, some risk is not rewarded. Investors need to control or eliminate risks for which they are not rewarded from their investment portfolio. Investment risks can be placed into two broad categories: unsystematic and systematic risks.

Unsystematic risk

Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk could include dramatic events such as a strike, a natural disaster such as a fire, or something as simple as slumping sales. Two common sources of unsystematic risk are business risk and financial risk.

Diversification and unsystematic risk

Diversification can greatly reduce unsystematic risk from a portfolio. It is unlikely that events such as the ones listed above would happen in every firm at the same time. Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic risk.

Systematic risk

On the other hand, some events can affect all firms at the same time. Events such as inflation, war, and fluctuating interest rates influence the entire economy, not just a specific firm or industry.

Diversification cannot eliminate the risk of facing these events. Therefore, it is considered un-diversifiable risk. This type of risk accounts for most of the risk in a well-diversified portfolio. It is called systematic risk or market risk. However, the expected returns on their investments can reward investors for enduring systematic risks.

Investors are induced to take risks for potentially higher returns. However, not all risks offer such potential rewards. The wise investor identifies these risks and eliminates them from his or her portfolio through diversification.