Systematic vs. Unsystematic Risk and the Risk Premium
In the realm of investing, risk and return go hand in hand. Investors expect to be compensated for taking on risk, and this compensation is known as the risk premium. However, not all risks are created equal. Systematic risk and unsystematic risk are two distinct types of risk that have different implications for investors.
Systematic Risk
Systematic risk, also known as market risk, is the risk that affects the entire market or economy. It is inherent in the overall investment environment and cannot be diversified away. Examples of systematic risk include economic downturns, interest rate changes, and political instability.
Key Facts
- Systematic risk refers to the risk that is inherent in the overall market or economy, affecting all investments to some degree. It cannot be eliminated through diversification.
- Unsystematic risk, also known as specific risk or company-specific risk, is the risk that is unique to a specific company or industry. It can be reduced through diversification.
- The risk premium is the additional return that investors require for taking on risk. It compensates investors for bearing the uncertainty and potential losses associated with investing in risky assets.
- Both systematic and unsystematic risk contribute to the total risk of an investment. The total risk premium is the compensation that investors receive for taking on both types of risk.
- Systematic risk is generally considered to be non-diversifiable and cannot be eliminated through diversification. Therefore, it is often associated with a risk premium.
- Unsystematic risk, on the other hand, can be reduced or eliminated through diversification. As a result, it may not require a risk premium if it can be effectively diversified away.
Since systematic risk cannot be eliminated, investors require a risk premium for bearing it. The risk premium for systematic risk is typically reflected in the expected return on the market portfolio, which is the portfolio that represents the entire stock market.
Unsystematic Risk
Unsystematic risk, also known as specific risk or company-specific risk, is the risk that is unique to a specific company or industry. It is not inherent in the overall market and can be reduced through diversification. Examples of unsystematic risk include management changes, product failures, and regulatory changes.
Unsystematic risk does not require a risk premium because it can be diversified away. By investing in a diversified portfolio, investors can reduce their exposure to unsystematic risk and, therefore, do not need to be compensated for bearing it.
Conclusion
The distinction between systematic and unsystematic risk is crucial for investors. Systematic risk is non-diversifiable and requires a risk premium, while unsystematic risk can be diversified away and does not require a risk premium. Understanding this distinction can help investors make informed decisions about their investment portfolios and manage their risk exposure effectively.
Sources
- Risk Premium – Demystifying Risk-Free Rate & The Role of Risk Premium
- What Is Unsystematic Risk? Types and Measurements Explained
- What Are Some Common Examples of Unsystematic Risk?
FAQs
What is systematic risk?
Systematic risk is the risk that affects the entire market or economy. It is inherent in the overall investment environment and cannot be diversified away.
What is unsystematic risk?
Unsystematic risk is the risk that is unique to a specific company or industry. It is not inherent in the overall market and can be reduced through diversification.
What is the risk premium?
The risk premium is the additional return that investors require for taking on risk. It compensates investors for bearing the uncertainty and potential losses associated with investing in risky assets.
Does systematic risk require a risk premium?
Yes, systematic risk requires a risk premium because it cannot be diversified away. Investors expect to be compensated for bearing this type of risk.
Does unsystematic risk require a risk premium?
No, unsystematic risk does not require a risk premium because it can be diversified away. By investing in a diversified portfolio, investors can reduce their exposure to unsystematic risk and, therefore, do not need to be compensated for bearing it.
How can investors reduce their exposure to systematic risk?
Systematic risk cannot be eliminated, but investors can reduce their exposure to it by investing in a diversified portfolio. Diversification helps to spread risk across different asset classes and industries, reducing the impact of any one particular risk factor.
How can investors reduce their exposure to unsystematic risk?
Unsystematic risk can be reduced through diversification. By investing in a diversified portfolio, investors can reduce their exposure to the specific risks of any one company or industry.
What is the relationship between systematic and unsystematic risk?
Systematic and unsystematic risk are two components of total risk. Total risk is the overall risk of an investment, and it is the sum of systematic and unsystematic risk.