What is systematic risk and unsystematic risk?
Risk is commonly known as a situation involving exposure to danger or harm. When it comes to investment decisions, the deviation between actual and expected returns is the risk in investment.
Total risk consists of two parts i.e. systematic risk and unsystematic risk. Let us try to understand what these risks are -
The part of risk that affects the entire system is known as systematic risk. These risks are applicable to the entire financial market or a wide range of investments. These risks are also known as undiversifiable risks because they cannot be eliminated through diversification. Systematic risk is caused due to factors that may affect the economy or markets as a whole, such as changes in government policy, external factors, wars, or natural calamities.
One of the best examples to explain systematic risk is the 2008 financial crisis, which affected economic growth. RBI’s move to increase interest rates in order to control inflation led to a fall in the prices of all bonds during that period. Thus, inflation risk, exchange rate risk, interest rate risk, and reinvestment risk comes under systematic risks.
To reduce systematic risk, one must adopt asset allocation strategy i.e. to add non-correlating asset classes such as bonds, commodities, currencies, and real estate to the equities in the portfolio.
The part of risk that can be diversified away is known as unsystematic risk. It is the risk specific to individual securities or a small class of investments. Hence, it can be diversified away by including other assets in the portfolio. Unsystematic risk is also known as diversifiable risk. Credit risk, business risk, and liquidity risks are unsystematic risks.
This can be explained with an example. Suppose Mr A invests majorly in chemical stocks and due to some macro-economic factors, the crude oil (raw material) prices are hiked; the profitability of these companies will be impacted, leading to a fall in the stock prices. Instead, if he would have diversified across other sectors, he could have avoided the losses.
Unsystematic risks in a portfolio can be reduced by diversification. This means that the portfolio should hold investments, whose risks & returns react differently to the same set of events. The equity portfolio should be diversified across various sectors as well as market cap categories i.e. large-cap, mid-cap, and small-cap stocks.