Systematic and Unsystematic Risk

Systematic Risk

Systematic risk is vulnerability to events which affect aggregate outcomes. Aggregate outcomes are effects measured at the total economy level. For example:

1. Aggregate supply (total supply of resources in an economy)
2. Aggregate demand (total demand for resources in an economy)
3. Aggregate income (total of all incomes in an economy)

Events which affect aggregate outcomes are usually either political (e.g. war and regulatory policy) or biological (e.g. infectious disease) and are therefore difficult to predict, but more importantly, they tend impact all market participants simultaneously. It is this simultaneous impact at the aggregate level (i.e. to all market participants) that prevents investors from diversifying against systematic risk. Hence, systematic risk is sometimes referred to as undiversifiable risk or aggregate risk, and may only be partially mitigated through hedging and/or appropriate asset allocation. Asset classes and asset allocation will covered in other articles.

Unsystematic Risk

Unsystematic risk is vulnerability to events which affect individual outcomes. Individual outcomes are effects measured at the company or industry level. For example:

• Market share
• Competitive advantage
• Operational efficiency

Although events which affect individual outcomes are also difficult to predict, they are experienced at the company or industry level, and therefore, they don't affect all market participants simultaneously. This means that investors may diversify against unsystematic risk by investing in companies and industries that do not share common traits or economic environments. Hence, unsystematic risk is sometimes referred to as diversifiable risk, specific risk or idiosyncratic risk.

Understanding the Difference

To reinforce the concept of systematic versus unsystematic risk, consider the following example: if one owns only one (1) stock, both the systematic and unsystematic risk of the portfolio remains very high. The market could crash due to an economic recession (systematic risk), or the company could lose multiple key customers leading to bankruptcy (unsystematic risk). However, if one owns five hundred (500) stocks (e.g. through the ownership of an index fund), then the unsystematic risk becomes practically zero as if one of the companies goes bankrupt, then the portfolio is only slightly affected. The systematic risk on the other hand would remain the same as the exposure to an economic recession still remains a risk to all five-hundred (500) companies.

Concept Overlap

It is important to note that the same risk can be categorised as either systematic or unsystematic depending on the extent of its influence. For example, regulatory policy risk, although usually systematic, can also be unsystematic if the policy in question affects a select few companies in a particular industry (e.g. steel import and export tariffs would affect the materials industries).

Summary

To summarise, risk can be broadly categorised as either systematic or unsystematic depending on whether the effects manifest at the aggregate (whole market), or individual (company or industry) level, respectively. The key piece of information to take home is that unsystematic risks may be almost entirely mitigated through company and industry diversification; whereas, systematic risks may only be partially mitigated through the use of hedging and/or appropriate asset allocation.

	Systematic Risk	Unsystematic Risk
Affected level	Aggregate (economy)	Individual (company/industry)
Mitigation	Hedging or asset allocation	Diversification
Examples	War, regulatory policy	Management, product marketability