Systematic Risk vs Unsystematic Risk

The risk is the degree of uncertainty in any stage of life. For instance, while crossing the road, there is always a risk of getting hit by a vehicle if precautionary measures are not undertaken. Similarly, in the area of investment and finance, various risks exist since the hard-earned money of individuals and firms are involved in the cycle.

Systematic Risk does not have a specific definition but is an inherent risk existing in the stock market. These risks are applicable to all the sectors but can be controlled. If there is an announcement or event which impacts the entire stock market, a consistent reaction will flow in which is a systematic risk. E.g., if Government Bonds is offering a yield of 5% in comparison to the stock market, which offers a minimum return of 10%. Suddenly, the government announces an additional tax burden of 1% on stock market transactions; this will be a systematic risk impacting all the stocks and may make the Government bonds more attractive.

Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is also known as “Specific Risk,” “Diversifiable risk ,” or “Residual Risk.” These are risks which are existing but are unplanned and can occur at any point in causing widespread disruption. E.g., if the staff of the airline industry goes on an indefinite strike, then this will cause risk to the shares of the airline industry and fall in the prices of the stock impacting this industry.

One should keep in mind the below formula, which in a nutshell highlights the importance of these 2 types of risks faced by all kinds of investors:

Systematic Risk vs Unsystematic Risk formula

The above risks cannot be avoided, but the impact can be limited with the help of diversification of shares into different sectors for balancing the negative effects.

What is Systematic Risk?

It is the risk that highlights the possibility of a collapse of the entire financial system or the stock market causing a catastrophic impact on the entire system in the country. It refers to the risks caused by financial system instability, potentially catastrophic or idiosyncratic events to the interlinkages, and other interdependencies in the overall market.

Let us consider the below example for a clearer understanding:

E.g., Mr ‘A’ has made a portfolio constituting 500 shares of a Media company, 500 Corporate bonds, and 500 Government bonds. The Central Bank has announced a recent interest rate cut due to which Mr ‘A’ wants to reconsider the impact on his portfolio and how he can re-work around it. Given that the Beta of the portfolio is 2.0, it is assumed that portfolio returns will be fluctuating 2.0 times more than the market returns.

If the market spikes by 3%, the portfolio will increase by 3%*2.0 = 6%. On the other hand, if the market falls by 3%, the overall portfolio will also decrease by 6%. Accordingly, Mr ‘A’ will have to lower the exposure of stocks and perhaps increase exposure in bonds as the fluctuations are not sharp in bonds compared to stocks. The asset allocation can be considered 250 shares of Media firm, 500 Corporate Bonds, and 750 Municipal bonds. It may seem to be a defensive mode, but Municipal bonds are perhaps the most secure in terms of a default offering stable returns.

Generally, risk-averse investors will prefer a portfolio of beta less than 1 so that they have to incur lower losses in case of a sharp market decline. On the other hand, risk-takers will prefer securities with high betas aiming for higher returns.

The sources of systematic risks can be:

Political instability or other Governmental decision having widespread impact
Economic crashes and Recession
Changes in taxation laws
Natural Disasters
Foreign Investment Policies

Systematic risks are difficult to be mitigated since these are inherent in nature and not necessarily controlled by an individual or a group. There is no well-defined method for handling such risks. Still, as an investor, one can consider diversification into various securities to perhaps reduce the impact of idiosyncratic situations, causing a ripple effect of such risks.

What is Unsystematic Risk?

Also known as Diversifiable or Non-systematic risk, it is the threat related to a specific security or a portfolio of securities. Investors construct these diversified portfolios for allocating risks over various classes of assets. Let us consider an example of a clearer understanding:

On March 1, 2016, Mr. Matthew invests $50,000 in a diversified portfolio, which invests 50% in stocks of Automobile companies, 20% in I.T. stocks, and a balance of 30% in stocks of Airline companies. On February 28, 2017, the value of the portfolio is enhanced to $57,500 thereby bringing annual growth of 15% [$57,500 – $50,000 *100]

One fine day, he gets to know that one of the airlines has defaulted on employee salary payments due to which the employees are on strike, and other airlines are expected to follow the same tactic. The investor is worried and one option to be considered for Mr. Matthew is to either hold on to the investment with the expectation of the issue getting resolved or he can divert those funds to other sectors that are experiencing stability or maybe divert them in bond investments.

Some of the other examples of unsystematic risks are:

Change in regulations impacting one industry
The entry of a new competitor in the market
A firm forced to recall one of its products (E.g., the Galaxy Note 7 phone recalled by Samsung due to its battery turning flammable)
A company exposed to have made fraudulent activities with its financial statements (For instance, Satyam computers fudging their balance sheets)
An employee union tactic for senior management to meet their demands

The existence of unsystematic risks means the owner of a company’s securities is at risk of adverse changes in the value of those securities due to the risk caused by the organization. Diversification is one of the options to reduce the impact, but it will still remain subject to Systematic risk that impacts the whole market. More is the diversification; lower will be the residual risk in the overall position. Unsystematic risk is measured and managed through the implementation of various risk management tools, including the derivatives market. Investors can be aware of such risks, but various unknown types of risks can crop up at any time, thereby increasing the level of uncertainty.

Systematic Risk and Unsystematic Risk Differences

Let us understand the differences between Systematic Risk vs. Unsystematic Risk in detail:

Systematic risk is the probability of a loss associated with the entire market or the segment. Whereas, Unsystematic risk is associated with a specific industry, segment, or security.
Systematic risk is uncontrollable in nature since a large scale, and multiple factors are involved. Whereas, unsystematic risk is controllable as it is restricted to a particular section. Unsystematic risks are caused due to internal factors that can be controlled or reduced in a relatively short time.
Systematic Risk affects many securities in the market due to widespread impact such as interest rate decreases by the Central Bank of a country. In contrast, Unsystematic risk will affect the stock/securities of a particular firm or sector, e.g., the strike caused by the workers of the Cement industry.
Systematic Risk can be substantially controlled through techniques like Hedging and Asset allocation. Conversely, unsystematic risk can be eliminated through diversification of a portfolio .
Systematic Risk is divided into 3 categories, i.e., Interest Rate Risk, Purchasing Power risk, and Market risk. In contrast, Unsystematic risk is bifurcated into two broad categories, namely Business Risk and Financial Risk .