What is the difference between systematic and unsystematic risk? What are causal factors that lead to these types of risks and how can they be effectively dealt with? Read to find all the answers.
Risk comes from not knowing what you are doing. - Warren Buffett
Risk is anything that can cause deviation from an expected outcome. In common economics parlance, risk is anything that is going to hamper the expected return on an investment.
As the world's financial markets are influenced by macro-level and micro-level developments, risk is tough to tackle. To effectively neutralize it, one has to first understand it. Its two main types are systematic and unsystematic risk.
Like a medical diagnostician labels every ailment and defines its symptoms, causes, and treatment, anyone acting as his own investment manager, must comprehend and analyze factors by which both the risks arise.
This thorough study will enable you to build effective hedging strategies that can negotiate the uncertainty and risk associated with investments. Here's a brief introduction to both types.
Systematic Risk: The One You Can't Avoid
Systematic risk arises from changes in local and global macroeconomic parameters - economic policy decisions made by governments, decisions of central banks that affect lending interest rates, inflation, economic recession.
It is the risk that plagues the entire market and is therefore, also termed as market risk, volatility, aggregate risk, or undiversifiable risk in some cases.
It arises due to the inherent dynamic nature of an economy, broader market outcomes, inflation, and all types of unavoidable global and local macroscopic factors.
In quantitative finance, the exposure of an investment to systematic risk is quantified by its Beta (β) value, which is a measure of the potential volatility of the asset.
A lower beta indicates lesser volatility; however, a higher value indicates an investment that is highly vulnerable to macroscopic systematic risk that plagues the market.
The only way to negotiate this risk is to not invest in securities with high beta values and go for zero-beta options. But then you have to be satisfied with low returns. You cannot completely eliminate it, but have to learn to live and trade with.
Lastly, this type of risk should not be confused with systemic risk, which is associated with the complete annihilation of a financial market, due to cascading effects triggered by major fault lines.
Unsystematic risk is connected with specific sectors and arises due to problems that are endemic to a particular company or sector that you are invested in.
Unsystematic Risk: The Manageable Variety
Some examples are labor strikes, drop in sales of a company, product recalls, managerial change, drastically-affecting regulatory change, sudden rise of competitors, or any problem due to human level error in judgement at managerial level.
This kind may be limited to a specific business or a sector and can therefore be actually neutralized through wide diversification.
For example, if the risk is associated with a particular sector, you could distribute your investments over multiple sectors to downplay its impact.
Hence, this type is also known as diversifiable or specific risk, which can be certainly avoided.
Difference Between Systematic Risk and Unsystematic Risk
Systematic risk affects the entire market as a whole, while the unsystematic variety may affect a certain company or sector. Therefore, the latter is avoidable, while the former isn't.
Unsystematic risk can be eliminated or reduced through diversification of the portfolio over a wide range of sectors or security types.
One can diversify an investment portfolio to eliminate the endemic risk that plagues a certain sector. However, systematic risk cannot be eliminated as its effects sweep the entire economy, as well as the market.
To really anticipate it, one needs to study the dynamics of an economy and the effects of policy decisions quite deeply. While this may not help you entirely eliminate it, it may help you brace for it.
One can keep unsystematic risk to a minimum with thorough stock research and spreading out of investments over diverse sectors, but its unsystematic counterpart, simply cannot be eliminated entirely.
It cannot be taken out of the equation entirely and therefore, it should never be ignored. Make your investments smartly, by taking both these risks into consideration.
Only invest what you can afford to lose in the markets. Let your decisions be based on thorough research of the fundamentals, instead of wild speculation.