Systematic vs Unsystematic Risk | CFA Level I Portfolio Management
Welcome back! Today, we’ll dive into the fascinating world of systematic and unsystematic risk, which affect individual assets and portfolios. Let’s jump right in!
Unraveling Systematic and Unsystematic Risk
Unsystematic risk is the risk that is local or limited to a specific asset or industry. It can be due to factors such as earnings misses, accounting fraud, or winning a major contract. Unsystematic risk can be avoided through diversification, by forming a portfolio of assets that are not highly correlated with one another. This type of risk is also known as company-specific, industry-specific, or diversifiable risk.
On the other hand, systematic risk is the risk that affects the entire market or a broad market segment. Common sources of systematic risk include interest rates, inflation, political uncertainty, and widespread natural disasters. Systematic risk is non-diversifiable because such risk factors affect the market as a whole.
Investing in a security typically involves exposure to both systematic and unsystematic risk. The total risk is the sum of these two components.
Eliminating Unsystematic Risk through Diversification
As the number of securities in a portfolio increases, unsystematic risk gets diversified away, eventually becoming negligible. It has been suggested that a portfolio of 12 to 18 stocks is sufficient to achieve maximum diversification possible, depending on correlation of returns between the securities.
Pricing Risk and Proportions of Systematic and Unsystematic Risk
In an efficient market, two assets with the same risk should have market prices that reflect the same equilibrium returns. However, this is often not the case. Differences in proportions of systematic and unsystematic risk can account for differences in equilibrium returns between two assets with the same total risk.
For example, a biotech stock may have a high proportion of unsystematic risk, while a stock of a firm with a cyclical business may have a higher proportion of systematic risk. Since unsystematic risk is diversifiable, it is not reflected in an asset’s price. Only the systematic risk of a security is priced, leading to differences in expected returns between the two stocks.
To sum up, unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. Investors do not receive any return for accepting unsystematic risk. Therefore, risk-averse investors should hold well-diversified portfolios.
And that concludes this lesson on systematic and unsystematic risk. In our next lesson, we’ll learn about beta and how to calculate a stock’s beta. See you soon!