There is always a risk incorporated in every investment like shares or debentures. The two major components of risk systematic risk and unsystematic risk, which when combined results in total risk. The systematic risk is a result of external and uncontrollable variables, which are not industry or security specific and affects the entire market leading to the fluctuation in prices of all the securities.
On the other hand, unsystematic risk refers to the risk which emerges out of controlled and known variables, that are industry or security specific.
Systematic risk cannot be eliminated by diversification of portfolio, whereas the diversification proves helpful in avoiding unsystematic risk. Take a full read of this article to know about the differences between systematic and unsystematic risk.
Content: Systematic Risk Vs Unsystematic Risk
|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.|
|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|
Definition of Systematic Risk
By the term ‘systematic risk’, we mean the variation in the returns on securities, arising due to macroeconomic factors of business such as social, political or economic factors. Such fluctuations are related to the changes in the return of the entire market. Systematic risk is caused by the changes in government policy, the act of nature such as natural disaster, changes in the nation’s economy, international economic components, etc. The risk may result in the fall of the value of investments over a period. It is divided into three categories, that are explained as under:
- Interest risk: Risk caused by the fluctuation in the rate or interest from time to time and affects interest-bearing securities like bonds and debentures.
- Inflation risk: Alternatively known as purchasing power risk as it adversely affects the purchasing power of an individual. Such risk arises due to a rise in the cost of production, the rise in wages, etc.
- Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall consistently over a period along with other shares of the market.
Definition of Unsystematic Risk
The risk arising due to the fluctuations in returns of a company’s security due to the micro-economic factors, i.e. factors existing in the organization, is known as unsystematic risk. The factors that cause such risk relates to a particular security of a company or industry so influences a particular organization only. The risk can be avoided by the organization if necessary actions are taken in this regard. It has been divided into two category business risk and financial risk, explained as under:
- Business risk: Risk inherent to the securities, is the company may or may not perform well. The risk when a company performs below average is known as a business risk. There are some factors that cause business risks like changes in government policies, the rise in competition, change in consumer taste and preferences, development of substitute products, technological changes, etc.
- Financial risk: Alternatively known as leveraged risk. When there is a change in the capital structure of the company, it amounts to a financial risk. The debt – equity ratio is the expression of such risk.
Key Differences Between Systematic and Unsystematic Risk
The basic differences between systematic and unsystematic risk is provided in the following points:
- Systematic risk means the possibility of loss associated with the whole market or market segment. Unsystematic risk means risk associated with a particular industry or security.
- Systematic risk is uncontrollable whereas the unsystematic risk is controllable.
- Systematic risk arises due to macroeconomic factors. On the other hand, the unsystematic risk arises due to the micro-economic factors.
- Systematic risk affects a large number of securities in the market. Conversely, unsystematic risk affects securities of a particular company.
- Systematic risk can be eliminated through several ways like hedging, asset allocation, As opposed to unsystematic risk that can be eliminated through portfolio diversification.
- Systematic risk is divided into three categories, i.e. Interest risk, market risk and purchasing power risk. Unlike unsystematic risk, which is divided into two broad category business risk and financial risk.
The circumvention of systematic and unsystematic risk is also a big task. As external forces are involved in causing systematic risk, so these are unavoidable as well as uncontrollable. Moreover, it affects the entire market, but can be reduced through hedging and asset allocation. Since unsystematic risk is caused by internal factors so that it can be easily controlled and avoided, up to a great extent through portfolio diversification.