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Definition Of Systematic Risk
Systematic risk is also referred to as non-diversifiable risk or market risk. Systematic risk is the fluctuations in the returns on securities that occur due to macroeconomic factors. These factors could be the political, social or economic factors that affect the business. Systematic risk can be caused due to unfavorable reasons such as an act of nature like a natural disaster, changes in government policy, international economic components, changes in the nation’s economy, etc.
Systematic risk is further divided into three categories:
- Interest Risk
- Inflation Risk
- Market Risk
Definition Of Unsystematic Risk
The fluctuations in returns of a company arising due to micro-economic factors are termed as unsystematic risks. These risk factors exist within the company and can be avoided if necessary action is taken. The risk factors can include the production of undesirable products, labor strikes, etc.
Unsystematic risks are further divided into two categories:
- Business Risks
- Financial Risks
After gaining an insight into systematic and unsystematic risk, let’s have a look at the differences between the two.
Key Differences Between Systematic and Unsystematic Risk
The basic differences between systematic and unsystematic risk are explained in the following points:
Systematic risk refers to the probability of loss linked with the whole market segment such as changes in government policy for the specific industry. While risks associated with particular industry is referred to as unsystematic risks like labor strike.
Systematic risk occurs due to uncontrollable factors such as natural calamities. As opposed to the unsystematic risk which is due to controllable factors such as the production of undesirable products.
Systematic risk occurs due to macroeconomic factors such as social, economic and political factors. While the unsystematic risk occurs due to the micro-economic factors such as labor strikes.
Systematic risk distresses a large number of organizations in the market or an entire industry sector. Whereas, unsystematic risk distresses a particular company.
Systematic risk is divided into three categories namely, interest risk, market risk and purchasing power risk. While unsystematic risk is divided into categories namely business risk and financial risk.
Systematic risk + Unsystematic risk = Total risk
After understanding the system of systematic and unsystematic risk, let’s look at the examples for both to get a clearer view.
Example Of Systematic Risk
The Great Recession of 2008 proves to be a key example of systematic risk. People who had invested in all kinds of securities saw the values of their investments fall due to the market-wide economic event. The great recession affected various securities in diverse ways. Thus, investors who held stocks were affected in adverse ways as compared to those with wider asset allocations.
Example Of Unsystematic Risk
Unsystematic risks are majorly related to errors in entrepreneurial judgment. For example, a technology corporation might undertake market research and expect a rise in demand for smaller cell phones and digital watches in the coming year. For that, production lines are altered and capital is dedicated toward smaller devices.
However, the company realizes in the next year that consumers are more inclined towards bigger phones and watches. Thus, the inventory and machinery obtained by the company later sells at a major loss or remains unsold. This will in turn harm the stock prices of the company. Thus, all the other firms in the technology sector might perform well while this company will backtrack due to poor entrepreneurial foresight.
In financial management, the avoidance of both, systematic and unsystematic risk can prove to be difficult. External factors are involved in causing systematic risk, these factors are unavoidable as well as uncontrollable. Moreover, they affect the entire market but can be partially constrained through asset allocation and hedging. Unsystematic risk is caused by internal factors and can be controlled and avoided, up to a great extent by means of portfolio diversification.
What are some common examples of unsystematic risk? | Investopedia