Are you tired of hearing financial jargon thrown around without really understanding what it means? If so, we’ve got you covered! We’ll explore the similarities and differences between systematic and unsystematic risk.
Systematic risk refers to market-wide or economy-wide risk, while unsystematic risk refers to risk that is specific to an individual company.
Systematic vs. Unsystematic Risk
| Systematic Risk | Unsystematic Risk |
|---|---|
| Systematic risk refers to market-wide or economy-wide risk that affects the entire market. | Unsystematic risk refers to risk that is specific to an individual company and does not affect the entire market. |
| Examples of systematic risk include interest rate risk, inflation risk, political risk, and currency risk. | Examples of unsystematic risk include business risk, financial risk, management risk, product recall risk, lawsuits, and labor strikes. |
| It arises from external factors that affect the entire market, such as economic recession, war, or natural disasters. | It arises from internal factors specific to a company, such as a change in management, product recall, or lawsuits. |
| Systematic risk affects the entire market or a specific sector, whereas unsystematic risk affects only the company or industry it belongs to. | Systematic risk can result in large-scale market declines, while unsystematic risk can result in significant losses for individual companies. |
| It can be reduced through portfolio diversification, which involves investing in a variety of assets across different sectors and industries. | It can be reduced through company-specific diversification, which involves investing in different companies or industries to minimize the impact of company-specific risks. |
| Systematic risk is difficult to predict and cannot be avoided. | Unsystematic risk can be minimized by proper company analysis and management. |
| Examples of these include economic recession, war, natural disasters, and pandemics. | Examples of these include a change in management, product recall, lawsuits, labor strikes, and other company-specific risks. |
What are systematic and unsystematic risks?
Systematic risk is the type of risk that is inherent to an entire market or market segment. Systematic risk arises from factors that affect the overall economy, such as inflation, recessions, political instability, and interest rate changes.
Unsystematic risk, also known as unique or diversifiable risk, is the type of risk that is specific to a particular company or industry. This type of risk can be mitigated through diversification because it is not correlated with the overall market.
Similarities between systematic and unsystematic risk
- Both types of risk can impact an investor’s portfolio and potentially lead to financial losses.
- Both types of risk can be reduced through proper diversification techniques.
- Both types of risk require proper risk management strategies to mitigate potential losses.
- Both types of risk can be influenced by external factors such as changes in economic, political, or market conditions.
Examples of systematic and unsystematic risk
Systematic Risk:
- Economic recession
- Inflation risk
- Interest rate risk
- Political risk
- Natural disasters
- War and terrorism
- Pandemics
Unsystematic Risk:
- Business risk
- Financial risk
- Management risk
- Product recall risk
- Lawsuits
- Labor strikes
- Change in management or leadership.
Strategies to manage systematic and unsystematic risk
For systematic risk, hedging is often used to mitigate the effects of adverse events. Hedging involves taking on offsetting positions in different securities or assets in order to offset the potential losses from the original investment. For example, if you are worried about a decline in the stock market, you could hedge your portfolio by buying put options on a broad-based index like the S&P 500.
For unsystematic risk, diversification is key. By investing in a variety of different assets, you can minimize the impact of any one security’s performance on your overall portfolio. For example, if you invest in a mix of stocks, bonds, and real estate, then even if one asset class performs poorly, the others may offset those losses.
Key differences between systematic and unsystematic risk
- Definition: Systematic risk refers to market-wide or economy-wide risk, while unsystematic risk refers to risk that is specific to an individual company.
- Impact: Systematic risk affects the entire market or a specific sector, whereas unsystematic risk affects only the company or industry it belongs to.
- Causes: Systematic risk arises from external factors that affect the entire market, such as economic recession, war, or natural disasters. Unsystematic risk arises from internal factors specific to a company, such as a change in management, product recall, or lawsuits.
- Diversification: Systematic risk can be reduced through portfolio diversification, which involves investing in a variety of assets across different sectors and industries. Unsystematic risk can be reduced through company-specific diversification, which involves investing in different companies or industries to minimize the impact of company-specific risks.
- Difference between central and commercial banks
- Difference between Internal and External Economies of Scale
- Difference between domestic income and national income
Conclusion
Systematic risk affects all investments to some degree, while the unsystematic risk is specific to one investment or a few. Systematic risk can be managed by diversifying your portfolio and investing in different asset classes. Unsystematic risks can also be managed through careful research and analysis of individual investments before committing funds.
