Diversification – Systematic vs Unsystematic Risk
The most famous chart in finance shows total risk declining as you add more stocks, but flattening out after a point. That flat line is the Systematic Risk.
Unsystematic Risk (Diversifiable Risk)
- Definition: Risk that is specific to a company or industry.
- Examples: Strikes, lawsuits, regulatory fines, bad earning reports, fire in a factory.
- Solution: Hold a portfolio of 30+ stocks. If one factory burns down, it won't ruin your portfolio.
Systematic Risk (Non-Diversifiable Risk)
- Definition: Risk inherent to the entire market or economy.
- Examples: Interest rate hikes, inflation, war, pandemics, recessions.
- Reality: You cannot run away from this risk by buying more stocks. All stocks tank during a recession.
- Solution: Hedging (Derivatives), Asset Allocation (Gold/Bonds), or accepting it.
Note
The Limit of Diversification: You can diversify away "management stupidity risk" (Unsystematic), but you cannot diversify away "economy collapsing risk" (Systematic).
Total Risk Formula
Total Risk = Systematic Risk + Unsystematic Risk
Total_Variance = beta^2 * Market_Variance + Residual_Variance
When the number of assets (N) in a portfolio increases, the Unsystematic Risk tends towards zero.
Comparison Table
Systematic vs Unsystematic Risk
Systematic Risk
- Type: Market-wide factors.
- Examples: Inflation, War, Rates.
- Mitigation: Cannot be eliminated.
- Measure: Beta.
VS
Unsystematic Risk
- Type: Company-specific.
- Examples: Strikes, Lawsuits.
- Mitigation: Diversification.
- Measure: Standard Deviation of residuals.
Test Your Knowledge
Question 1 of 5
1. Which risk CANNOT be eliminated by diversification?