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Unsystematic vs. Systematic Risk

Unsystematic vs. Systematic Risk

Risk is an unavoidable part of trading. People who succeed in the financial markets are those who know how to manage risks effectively. And, risk management starts with understanding the types of risks associated with a trading instrument, industry or the overall market, and developing strategies accordingly.

The total risk associated with investment comprises of systematic risk and unsystematic risk.

Total Risk = Systematic risk + Unsystematic Risk

Systematic Risk

Also known as market risk, systematic risk is associated with either the entire market or a particular segment of the market. It is caused by economic, political and sociological changes, and is beyond the control of investors or the management of a firm. If there is an announcement or event affecting the entire financial market, it would be a systematic risk for the investor.

The Greek alphabet, Beta, is used to measure systematic risk associated with an instrument or a segment, in comparison to the whole market. It is also used to compare risks associated with a stock against that associated with other stocks.

For instance, the great recession of 2008 is a key example of systematic risk. It led to the collapse of various financial institutions. People saw the value of their investments across all types of financial instruments fall steeply due to the global impact of this event. Investors who had a diversified portfolio suffered lower losses, in comparison to those who only held stocks.

Sources of Systematic Risk

There are certain macroeconomic factors that may result in systematic risk, such as:

1.    Interest Rate Risk

This is the risk due to changing rates of interest from time to time. It affects all the major interest-bearing securities, such as debentures and bonds. It also leads to price risk, since there is an increase in the possibility that the prices of securities may decline in future. Interest rate risk also affects the reinvestment of returns on investment, since one cannot reinvest at the same rate of return.

2.    Market Risk

Variations in returns on most commonly traded instruments, due to change in expectations and behaviour of investors, results in market risk. It leads to significant fluctuations in prices of instruments within a short period of time, leading to uncertainty.

3.    Purchasing Power Risk

Also known as inflation risk, this type of risk occurs when there is uncertainty associated with the purchasing power of an investment to be received due to inflation or deflation. It is usually advisable to avoid investing during periods of high inflation.

Unsystematic Risk

Also known as diversifiable risk, specific risk or residual risk, unsystematic risk is company or industry specific risk, associated with a specific type of financial instrument. Such risk exists within an organisation but is unplanned and can pop up at any time, leading to high volatility in prices of instruments. This risk is mainly related to errors in judgement and mismanagement within an organisation.

For instance, a mobile phone manufacturer might invest in market research and development and expect a rise in demand for small-sized mobile phones and smart watches in future. For this, the company decides to make infrastructural changes and capital is invested on the development of smaller products. However, in the next year, the demand for larger-sized phones and watches increases.

The inventory and changes made to infrastructure turns out to be waste and the products remain unsold. Decline in demand for the products of this firm will affect its stock price. While its competitors might witness growth, this company would incur losses due to poor assessment and decision making by the management.

Sources of Unsystematic Risk

Unsystematic risk is caused by internal factors within an organisation, such as:

1.    Business Risk

Also known as liquidity risk, business risk arises due to fluctuations in sales, income, profits, etc., of a firm, due to a fall in production, technological problems, labour problems, raw material problems and so on. Changes in government policies, increase in competition, changes in consumer behaviour can also lead to business risk.

2.    Financial Risk

Also known as credit risk, financial risk occurs due to changes or irregularities in the methods adopted for financing by a firm. It may lead to short-term liquidity problems due to bad loans, resulting in financial risk. The debt-equity ratio of the company is used to judge the probability of this type of risk arising.

3.    Insolvency Risk

This occurs when a firm declares insolvency or defaults on a loan.

4.    Operational Risk

This type of risk takes place due to human error. It differs from industry to industry and may result in a breakdown of internal procedures, policies, systems and people.

Reducing the Risks

Systematic risks cannot be controlled, and investors tend to suffer losses. On the other hand, unsystematic risks can be minimised through the diversification of an investment portfolio. Greater the diversification, lower will be the overall risk.

Unsystematic risk can be measured and managed using risk management tools and alternate investment options, such as derivatives and CFDs. But any kind of risk can pop up at any time and increase the level of uncertainty.

Difference between Systematic and Unsystematic Risk

  Systematic Risk Unsystematic Risk
Meaning Refers to risk associated with a market or entire segment Refers to risk associated with a specific instrument, firm or sector
Factors responsible External Internal
Controllability Cannot be controlled Can be controlled
Affects Large number of instruments in the market Only a specific firm or sector
Hedging Allocation of assets Diversification of portfolio
Sources Interest risk, purchasing power risk, market risk Business risk, insolvency risk, financial risk
Avoidance Cannot be avoided Can be avoided or dealt with quickly

All investments have inherent risks associated with them, which cannot be avoided. Systematic and unsystematic risks provide insight into factors that need to be considered while investing. These risks cannot be completely avoided but investors can actively monitor events and their portfolio to minimise losses in the event of an unfavourable situation.

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