Systematic & Unsystematic Risk - CA Final SFM - Strategic Financial Management

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Systematic & Unsystematic Risk
All investments are subject to risk. It is generally believed that investors are rewarded for taking risk. However, some risk is not rewarded. Investors need to control or eliminate risks for which they are not rewarded from their investment portfolio. Investment risks can be placed into two broad categories: unsystematic and systematic risks. Unsystematic risk (also called diversifiable risk) is risk that is specific to a company.

“Diversification can greatly reduce unsystematic risk from a portfolio.”

Diversifiable risk (also known as unsystematic risk) represents the portion of an asset’s risk that is associated with random causes that can be eliminated through diversification. It’s attributable to firm-specific events, such as strikes, lawsuit, regulatory actions, and loss of a key account. Unsystematic risk is due to factors specific to an industry or a company like labor unions, product category, research and development, pricing, marketing strategy etc. There is no reward for taking on unneeded unsystematic risk. By diversifying, one can reduce unsystematic risk.

While the non-diversifiable risk (also known as systematic risk) is the relevant portion of an asset’s risk attributable to market factors that affect all firms such as war, inflation, international incidents, and political events. It cannot be eliminated through diversification and the combination of a security’s non-diversifiable risk and diversifiable risk is called total risk.

In other words Systematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, change in taxation clauses, shift in socio-economic parameters, global security threats and measures etc. Systematic risk is beyond the control of investors and cannot be mitigated to a large extent. In contrast to this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that can be avoided and the market does not compensate for taking such risks.

Note:
1. Variance Approach should always be preferred.
2. Unsystematic risk may or may not exist. In other words it can be either positive or zero. Unsystematic risk can never be negative because systematic risk cannot exceed the total risk.
3. Whenever a security or a portfolio has perfect positive correlation with market, then unsystematic risk for such security & portfolio shall not exist.

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