Definition
Systematic risk refers to the overall, unavoidable uncertainties and potential threats in the market or entire economic system, such as interest rate changes, recessions, or political instability. Unsystematic risk, on the other hand, relates to company or industry-specific hazards that can be mitigated through diversification, like changes in management, labor strikes, or product recalls. While systematic risk affects all investments, unsystematic risk can be reduced through effective portfolio management.
Key Takeaways
- Systematic risk refers to the overall risk that affects all sectors and companies in the market. It is inevitable and non-diversifiable. Common examples include changes in governmental policy, inflation rates, and global economic downturns.
- Unsystematic risk, often known as specific risk, impacts a specific industry or a particular company. It is unique and can be minimized through diversification in an investment portfolio. Examples include changes in management, product recall, and labor strikes.
- The key difference between systematic and unsystematic risk is that while systematic risk cannot be eliminated through diversification, unsystematic risk can be reduced significantly by spreading investments across a variety of assets or sectors.
Importance
The finance terms, Systematic Risk and Unsystematic Risk, are important because they help investors, financial analysts, and portfolio managers in assessing and managing the risks involved in investment decisions.
Systematic Risk, also known as market risk, pertains to risks that are uncontrollable and affect the entire market, such as interest rates, inflation, and recession.
On the other hand, Unsystematic Risk, also known as specific risk, relates to risks that are company-specific and can be managed or eliminated through diversification.
Understanding these two types of risks enables better mitigation strategies — investing in a mix of assets can balance out potential losses due to Unsystematic Risk, while hedging strategies can be a safety net for Systematic Risk, making these concepts crucial in successful financial planning and investment management.
Explanation
Systematic risk and unsystematic risk are important concepts used to understand, measure, and manage various kinds of risks in the field of finance. Systematic risk, also known as market risk or non-diversifiable risk, is associated with market-wide risks and uncertainties. This type of risk affects a large number of assets and ordinarily cannot be eliminated or minimized through diversification.
Such risks may arise due to macroeconomic factors like changes in inflation, political instability, changes in interest rates, or natural disasters. The purpose of identifying systematic risk is to understand the vulnerability of an investment to factors that affect the entire market or sector, which helps investors make informed decisions about managing their portfolio and mitigating potential losses. Unsystematic risk, on the other hand, is specific to a particular company or industry, and can be minimized or eliminated through diversification.
This category includes risks associated with a company’s operations, industry-specific factors, competition, regulatory changes, etc. The main purpose of identifying unsystematic risk is to make decisions concerning individual investments. By thoroughly evaluating a company or industry’s financial health, management competency, or sector trends, investors can mitigate this type of risk.
In essence, understanding both systematic and unsystematic risks allows investors to make better decisions by balancing the risk and reward trade-off, ultimately contributing to the optimization of their investment strategies.
Examples of Systematic Risk vs Unsystematic Risk
Stock Market Crash (Systematic Risk) vs. Bankruptcy of a Company (Unsystematic Risk): A sudden crash in the stock market is an example of a systematic risk as it affects all stocks and sectors alike due to the interconnected nature of the market. It is unpredictable and not easily avoidable by diversification. On the other hand, the bankruptcy of a specific company in which you’ve invested is an unsystematic risk. This risk is company-specific and can be avoided through diversification – if you have investments in other companies, the failure of one does not devastate your entire portfolio.
Changes in Interest Rates (Systematic Risk) vs. Labor Strikes (Unsystematic Risk): Changes in interest rates, increased taxes imposed by the government, or inflation are systemic risks that impact overall market and cannot be mitigated easily. Unsystematic risk is illustrated by events like labor strikes, supply chain issues, or management troubles inside a particular company. These incidents directly impact that company’s productivity and profitability, but won’t have a generalized impact on the entire economy.
Global Pandemic (Systematic Risk) vs. Product Recall (Unsystematic Risk): A global pandemic such as COVID-19 is a systematic risk as it impacts the whole economy, every industry, and geography leading to a potential economic slowdown or recession. Alternatively, an example of unsystematic risk would be a product recall by a company, like Toyota recalling the Prius due to design flaws. This issue solely affects Toyota and its investors, and not the entire automobile sector. Thus, investors who diversified their portfolio across different automotive companies are less impacted by this fallout.
Frequently Asked Questions: Systematic Risk vs Unsystematic Risk
What is Systematic Risk?
Systematic risk, also known as market risk, is the risk that is inherent to the entire market, not just a particular stock or industry sector. It cannot be eliminated through diversification. Examples of systematic risks include interest rates, inflation rates, and recessions.
What is Unsystematic Risk?
Unsystematic risk, also known as specific risk, is the risk that is specific to a particular company or industry. This type of risk can be reduced through diversification. Examples of unsystematic risks include new competition, regulatory changes, and poor management.
What is the main difference between Systematic Risk and Unsystematic Risk?
The main difference between systematic and unsystematic risk is that systematic risk affects the entire market, and is therefore unpredictable and unavoidable. On the other hand, unsystematic risk is specific to a particular company or industry, and can be reduced or eliminated through diversification.
Why is understanding the difference between Systematic and Unsystematic risk important to investors?
Understanding the difference between systematic and unsystematic risk is crucial for investors as it can help them make informed investment decisions. For instance, understanding these risks can help investors decide how to diversify their portfolio, determine the level of risk they are willing to accept, and set realistic investment goals.
Related Entrepreneurship Terms
- Portfolio Diversification
- Market Risk
- Business Risk
- Non-Diversifiable Risk
- Specific Risk
Sources for More Information
- Investopedia: A comprehensive source that covers financial news, terms, and offers educational content.
- The Balance: Offers a wide range of advice and information on topics related to personal finance, investing, and retirement planning.
- Corporate Finance Institute: Provides online financial training courses and certification programs.
- Morningstar: Provides comprehensive investment management information with analysis, news, and research.
