Systematic vs Un-Systematic Risk

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Any investment in the market will always have some degree of risk; whether we invest in shares, bonds, real estate or any market, we simply cannot make an investment risk free. Though there are certain investments like Treasury bonds which are considered to be risk free but return on such investment is generally very low.

Risk associated with investments can generally be divided into two factors; Systematic Risk or Unsystematic Risk.

Systematic Risk: Systematic risk is defined as non-diversifiable risk which affects the whole market rather than a particular security or industry. Systematic risk arises as a result of factors like socio-political environment within a particular country, a natural calamity or macro-economic factors like 2008 recession which affects the whole market.

Systematic risk though cannot be completely mitigated but there are certain strategies which could help it to tackle better; like hedging or optimized asset allocation.

E.G. To be in better position during period of economic downturn or recession an investor should allocate money into fixed income, cash and real estate.

Un-Systematic Risk: Un-Systematic risk is specific to a particular company or industry; thus un-systematic risk can be reduced through diversification. For example, news that is specific to a small number of stocks or a company, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.

Nature of Risk:

Systematic Risk: It is non-diversifiable risk, so it cannot be reduced or controlled by the asset management. Change in interest rate, inflation, price changes, high unemployment rate etc are the common examples of this types of risk.

Unsystematic Risk: It is diversifiable risk, so it can be reduced or controlled by the diversification or asset management. High labor turnover, high operational cost, strike in the company etc. are the examples of unsystematic risk.

Important Factors of Systematic Risk:

Market Risk: Market risk influences the whole market and most of the investment portfolios move along with market news. Like in 2008 recession whole market crashed and thus almost all the investment portfolios observed losses.

Interest Risk: Any change in interest rate affects the interest bearing securities like bonds and debentures.

Inflation Risk (Purchasing Power): Risk associated with inflation affects the purchasing power of investors which affects the whole market.

Exchange Rate Risk: In globalized economy; most of the big investors have exposures across countries thus exchange rate risk could actually impact whole market of a country in case of exchange rate fluctuations.

Types of Un-Systematic Risk:

Business Risk (Micro-Economic Factors): Risk inherent to a particular company or industry could result into company or industry specific price fall. In case of a strike of workers stock prices might go down but this price fall would be specific to a particular company and could be reduced by diversification. Certain policy change could affect an industry but again this kind of risk could be reduced by investing in different sectors.

Financial Risk: Financial risk arises as a result of capital structure of a particular market; in other words methods of financing used by the firm like equity or debt and even short-term liquidity problems due to bad-debts results in financial risk.

Customer Insolvency Risk: The borrower of funds may become insolvent or may default. This risk is termed as insolvency risk caused because of firms decisions.

Comparison Table:

BASIS FOR COMPARISON SYSTEMATIC RISK UNSYSTEMATIC RISK
Meaning Systematic risk refers to the hazard which is associated with the market or market segment as a whole. Unsystematic risk refers to the risk associated with a particular security, company or industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the market. Only particular company.
Types Interest risk, market risk and purchasing power risk. Business risk and financial risk
Protection Asset allocation Portfolio diversification

 

1 COMMENT

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