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Types of Risk: Systematic vs. Unsystematic 🏹🛡️

In Portfolio Management, all the sources of risk we discussed earlier are grouped into two major categories based on whether they can be removed through smart investing. This classification is the "secret sauce" of modern finance.

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1. Systematic Risk (Non-Diversifiable)

Systematic Risk refers to the risks that affect the entire market or the entire economy. No matter how many different stocks you buy, you cannot escape this risk.

  • Nature: It is inherent in the "system." It is external to the company and caused by broad factors.
  • Sources:
    • Market Risk: General swings in investor psychology.
    • Interest Rate Risk: Changes in central bank rates.
    • Purchasing Power Risk: Inflation.
  • Measurement: Measured by Beta (β).
Warning

You cannot reduce Systematic Risk by adding more stocks to your portfolio. You can only reduce it by shifting your money into "safer" asset classes like Cash or Treasury Bills.

2. Unsystematic Risk (Diversifiable)

Unsystematic Risk is the risk that is unique to a specific company or a specific industry. If one company's factory burns down, it doesn't mean other companies' factories will also burn down.

  • Nature: It is "local" or "specific."
  • Sources:
    • Business Risk: (e.g., a strike in a paper mill).
    • Financial Risk: (e.g., a specific company's default on a loan).
  • The Hero Solution: Diversification. By buying 20-30 different stocks from different industries, the bad news in one is offset by good news in another.

3. Total Risk

Total Risk is simply the combination of both.

Total Risk = Systematic Risk + Unsystematic Risk

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The Diversification Diagram 📉

As you add more securities to your portfolio, the Unsystematic Risk drops toward zero, but the Systematic Risk remains constant as an "unbreakable floor."

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Exam Pattern Questions and Answers

Question 1: "Differentiate between Systematic and Unsystematic Risk." (8 Marks)

Answer:

  1. Scope: Systematic risk affects the entire market (wide scope); Unsystematic risk affects only a specific firm or industry (narrow scope).
  2. Control: Systematic risk is caused by external factors (inflation, interest rates) and is uncontrollable; Unsystematic risk is caused by internal factors (strikes, management) and can be controlled through diversification.
  3. Diversification: Systematic risk is "non-diversifiable"; Unsystematic risk is "diversifiable."
  4. Reward: Investors are generally only compensated for taking Systematic Risk, as they are expected to eliminate Unsystematic risk themselves through diversification.

Summary

  • Systematic Risk = Unavoidable; affects everyone.
  • Unsystematic Risk = Avoidable through Diversification.
  • Total Risk = The sum of both.
  • In an efficient market, an investor is rewarded for taking systematic risk only.

Quiz Time! 🎯

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