Systematic Risk vs Unsystematic Risk

The risk is the degree of uncertainty in any stage of life. For instance, there is always a risk of getting hit by a vehicle if preventive measures are not undertaken while crossing the road. Similarly, in investment and finance, various risks exist since the hard-earned money of individuals and firms is involved in the cycle.

This article shall focus on the differences between Systematic and Unsystematic Risk. These risks are inevitable in any financial decision, and accordingly, one should be equipped to handle them if they occur.

• Systematic risk does not have a specific definition but is an inherent risk existing in the stock market. These risks apply to all the sectors but can be controlled. A consistent reaction will flow if an announcement or event impacts the entire stock market, which is a systematic risk. E.g., if Government Bonds offer a yield of 5% compared to the stock market, which provides a minimum return of 10%. Suddenly, the government announces an additional tax burden of 1% on stock market transactions; this will be a systematic risk impacting all the stocks and may make the Government bonds more attractive.
• Unsystematic risk is an industry or firm-specific threat in each kind of investment. It is also known as "Specific Risk," "Diversifiable risk," or "Residual Risk." These are existing risks but are unplanned and can occur at any point, causing widespread disruption. E.g., if the airline industry staff goes on an indefinite strike, this will cause risk to the shares of the airline industry and a fall in the prices of the stock impacting this industry.

One should keep in mind the below formula, which in a nutshell highlights the importance of these two types of risks faced by all kinds of investors:

The above risks are unavoidable, but the impact can be limited with the help of diversification of shares into different sectors for balancing the negative effects.

Let us now look at the differences between Systematic Risk vs. Unsystematic Risk in infographics format.

The risk highlights the possibility of a collapse of the entire financial system or the stock market, causing a catastrophic impact on the whole system in the country. It refers to the risks caused by financial system instability, potentially catastrophic or idiosyncratic events to the interlinkages, and other interdependencies in the overall market.

Let us consider the below example for a clearer understanding:

E.g., Mr' A' has made a portfolio constituting 500 shares of a Media company, 500 Corporate bonds, and 500 Government bonds. The Central Bank has announced a recent interest rate cut, due to which Mr' A' wants to reconsider the impact on his portfolio and how he can re-work around it. Given that the portfolio's beta is 2.0, it is assumed that portfolio returns will fluctuate 2.0 times more than the market returns.

If the market spikes by 3%, the portfolio will increase by 3%*2.0 = 6%. On the other hand, if the market falls by 3%, the overall portfolio will decrease by 6%. Accordingly, Mr' A' will have to lower the exposure of stocks and perhaps increase bond exposure as the fluctuations are not sharp in bonds compared to stores. The asset allocation can be considered 250 shares of Media firm, 500 Corporate Bonds, and 750 Municipal bonds. It may seem to be a defensive mode, but Municipal bonds are perhaps the most secure in terms of a default offering stable returns.

Generally, risk-averse investors will prefer a portfolio of beta less than one so that they have to incur lower losses in case of a sharp market decline. On the other hand, risk-takers will prefer securities with high betas aiming for higher returns.

The sources of systematic risks can be:

• Political instability or other Governmental decisions having a widespread impact
• Economic crisis and Recession
• Changes in taxation laws
• Natural Disasters
• Foreign Investment Policies

Systematic risks are difficult to be mitigated since these are inherent and not necessarily controlled by an individual or a group. Moreover, there is no well-defined method for handling such risks. Still, as an investor, one can consider diversification into various securities to perhaps reduce the impact of distinctive situations, causing a ripple effect of such risks.

Also known as Diversifiable or Non-systematic risk, it is the threat related to a specific security or a portfolio of securities. Investors construct these diversified portfolios for allocating risks over various classes of assets. Let us consider an example of a clearer understanding:

On March 1, 2016, Mr. Matthew invested $50,000 in a diversified portfolio, which invests 50% in stocks of Automobile companies, 20% in I.T. stocks, and a balance of 30% in stocks of Airline companies. On February 28, 2017, the value of the portfolio is enhanced to $57,500 thereby bringing annual growth of 15%

One fine day, he gets to know that one of the airlines has defaulted on employee salary payments, due to which the employees are on strike, and other airlines are expected to follow the same tactic. Naturally, the investor is worried. One option for Mr. Matthew is to either hold on to the investment with the expectation of the issue getting resolved or divert those funds to other sectors experiencing stability or maybe divert them into bond investments.

Some of the other examples of unsystematic risks are:

• Change in regulations impacting one industry
• The entry of a new competitor in the market
• A firm forced to recall one of its products (E.g., the Galaxy Note 7 phone recalled by Samsung due to its battery turning flammable)
• A company exposed to having made fraudulent activities with its financial statements (For instance, Satyam computers fudging their balance sheets)
• An employee union tactic for senior management to meet their demands

Unsystematic risks mean the owner of a company's securities is at risk of adverse changes in the value of those securities due to the trouble caused by the organization. Diversification is one of the options to reduce the impact, but it will remain subject to Systematic risk that impacts the whole market. More is diversification; the residual risk in the overall position will be lower. Unsystematic risk is measured and managed by implementing various risk management tools, including the derivatives market. Investors can be aware of such risks, but various unknown types of risks can crop up, thereby increasing the level of uncertainty.

Let us understand the differences between Systematic Risk vs. Unsystematic Risk in detail:

1. Systematic risk is the probability of a loss associated with the entire market or the segment. Whereas, Unsystematic risk is associated with a specific industry, segment, or security.
2. Systematic risk is uncontrollable on a large scale, and multiple factors are involved. At the same time, unsystematic risk is controllable as it is restricted to a particular section. Unsystematic risks are caused due to internal factors that can be controlled or reduced in a relatively short time.
3. Systematic risk affects many securities in the market due to widespread impacts such as interest rate decreases by the Central Bank of a country. In contrast, Unsystematic risk will affect the stock/securities of a particular firm or sector, e.g., the strike caused by the Cement industry workers.
4. Systematic risk can be substantially controlled through techniques like Hedging and Asset allocation. Conversely, unsystematic risk can be eliminated through diversification of a portfolio.
5. Systematic risk is divided into three categories, i.e., Interest Rate Risk, Purchasing Power risk, and Market risk. In contrast, Unsystematic risk is bifurcated into two broad categories: Business Business Risk and Financial Risk.

Any investment will have inherent risks associated with it, which cannot be avoided. Systematic Risk vs. Unsystematic Risk highlights these factors that must be accepted while making any investment.

These risks do not have any specific definition, but they will be a part of any financial investment. Though both Systematic Risk and Unsystematic Risk these types of risks cannot be completely avoided, an investor needs to be vigilant and periodically rebalance their portfolio or diversify their investments so that if any catastrophic event takes place, the investor can be less impacted in case of adverse events but also maximize gains in case of positive announcements.