Systematic and Unsystematic Risk

Systematic

Refers to the risk intrinsic to the complete market or the complete market segment. Systematic risk is also sometimes referred as “market risk” or “un-diversifiable risk”. As explained by Investopedia, recession, wars, and interest rate represent the sources for systematic risk for they affect the complete market and are unavoidable through diversification. While this risk type affects a wide range of securities, unsystematic risk affects quite a particular group of securities or even an individual security. Moreover, systematic risk can be reduced by just being hedged.

Unsystematic Risk

Unsystematic risk is company specific or industry specific risk. This is risk attributable or specific to the individual investment or small group of investments. It is uncorrelated with stock market returns. Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk.

Examples of risk that might be specific to individual companies or industries are business risk, financing risk, credit risk, product risk, legal risk, liquidity risk, political risk, operational risk, etc. Unsystematic risks are considered governable by the company or industry.

Investment diversification can nearly eliminate unsystematic risk. If an investor owns just one stock or bond and something negative happens to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 30, or 40 individual investments, the damage done to the portfolio is minimized.

The important concept of unsystematic risk is that it is not correlated to market risk and can be nearly eliminated by diversification.