Systematic Vs Unsystematic Risks

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:

Definition of Unsystematic Risk

Unsystematic risk, also named as nonsystematic risk or diversifiable risk,  is the fluctuations in returns of a company arising due to micro-economic factors. 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:

After gaining an insight into systematic and unsystematic risk, let’s have a look at the differences between the two.

Systematic vs Unsystematic Risk

Key Differences Between Systematic and Unsystematic Risk

The basic differences between systematic and unsystematic risk are explained in the following points:

Meaning

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 a particular industry is referred to as unsystematic risks like labor strike.

Nature

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.

Factors

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.

Affects

Systematic risk distresses a large number of organizations in the market or an entire industry sector. Whereas, unsystematic risk distresses a particular company.

Protection

Systematic risk can be eradicated through several ways like asset allocation or hedging. However, the unsystematic risk can be eradicated through portfolio diversification.

Categories

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.

Table of Differences

BasisSystematic RiskUnsystematic risk
MeaningAssociated with whole market segmentRisk associated with particular industry
NatureUncontrollableControllable
FactorsDue to macroeconomic factorsDue to microeconomic factors
AffectsLots of organization are affectedParticular company is affected
ProtectionThrough asset allocation/hedgingThrough portfolio diversification
Categories3 Types: Interest risk, market risk
& inflation risk
2 Types: Business risk & financial risk

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.

Examples of Systematic Risks

Examples of systematic risk are listed below:

  • Tax reforms
  • Interest rate hikes
  • Changes to law
  • Natural disasters
  • Political instability
  • Flight of capital
  • Changes in foreign policy
  • Currency value changes
  • Failure of banks
  • Economic recession

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.

Examples of Unsystematic Risks

Examples of unsystematic risk are listed below:

  • Competitive risk
  • Compliance risk
  • Errors in entrepreneurial judgement
  • Strategy risk
  • Outcomes of legal proceedings
  • Reputational risk
  • Investing risk
  • Inherent risk
  • Liquidity issue
  • Flawed business model
  • Labor strikes

Conclusion

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.

Frequently Asked Questions (FAQs)

Which one of the following is an example of unsystematic risk?

The various examples of unsystematic risk are competitive risk, strategy risk, outcomes of legal proceedings, etc.

Which one of the following is an example of systematic risk?

Examples of systematic risk are tax reforms, interest rate hikes, failure of banks, etc.

Which of the following is the best description of systematic risk?

Systematic risk can be defined as risk which is beyond the control of the management. Further it affects all the companies across the industry segments in general.

Can market risk can be eliminated in a stock portfolio through diversification?

Diversification reduces the overall volatility of the stock portfolio. The price movements of individual stocks at the aggregate level may average out and may not be so sharp. Hence, diversification definitely reduces the market risk but can not completely eliminate it.

Diversifiable risk examples

Examples of diversifiable risk are competitive risk, compliances, etc.

What happens if non diversifiable risk increases?

An increase in non diversifiable risk would affects market more than it affects the returns on stocks.

Share Knowledge if you liked
Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

Related Posts

Leave a Comment