Systematic vs. Unsystematic Risk: The Key Differences

Despite experiencing periods of significant volatility, the S&P 500 has delivered an average annual return of around 10% over the long term. This paradox highlights the two unavoidable forces shaping every investor's journey: systematic and unsystematic risk.

Systematic risks affect the financial market as a whole, whereas unsystematic risks are unique to a specific company or investment.

This article clarifies these concepts, exploring their definitions, key differences, and calculation methods. By the end, we hope you'll have a better understanding of how to navigate market turbulence, make better informed investment decisions, and implement more effective strategies for risk mitigation.

Whether you're a novice investor or seasoned trader, mastering the interplay between systematic and unsystematic risk is your key to unlocking portfolio resilience and long-term growth.

What are systematic risks?

Systematic risks are inherent risks that exist in the stock market. They’re also called “non-diversifiable risks” or “market risks” since they impact the entire asset class.

Non-diversifiable means that an organization can’t control, minimize, or avoid systematic risks. These risks are typically due to external factors like ongoing geopolitical situations, monetary policies, and natural disasters. For example, the COVID-19 pandemic was a systematic risk because it impacted the entire stock market.

Types of systematic risks

Consider a few types of systematic risks:

• Interest rate risk. Interest rate risk results from a change in the market interest rate. It mainly impacts fixed-income securities like bond prices and asset-backed securities. The yield on these securities is inversely related to the interest rate. As interest rates go up, investors find it more attractive to pull their money out of fixed-income securities.‍
• Market risk. Market risk results from the general tendency of investors to behave as per the market. For example, investors avoid investing in even the best-performing companies during a financial crisis. ‍
• Purchasing power risk. Also called inflation risk, purchasing power risk results from the decline in the purchasing power of money due to inflation. For example, if inflation is 5% per year, you’d need $10.50 to buy the pack of pens next year that cost $10 today.

The Federal Reserve's aggressive interest rate hikes since March 2022 led to a significant decline in bond prices, as higher rates reduce the present value of future bond payments. This is an example of interest rate risk and its impact on bond markets.

Market risk was starkly demonstrated during the COVID-19 pandemic, when the U.S. saw one of the biggest stock market crashes in history. Major stock indices plummeted in early 2020 due to widespread investor panic. Inflation risk became particularly evident in 2022-2023, as the U.S. experienced inflation rates of over 8%, significantly eroding consumers' purchasing power.

These real-world scenarios highlight how systematic risks can affect entire markets and economies, impacting a wide range of investments simultaneously.

What are unsystematic risks?

Unsystematic risks, also known as “nonsystematic risks,” “specific risks,” “diversifiable risks,” or “residual risks,” are unique to a specific company or industry. These risks arise due to various internal and external factors that affect only the particular organization but not the entire market.

Some examples of unsystematic risk include labor unrest at a factory, regulatory changes, and shortages of raw materials.

Unlike systematic risks, an organization can control, minimize, and possibly even avoid unsystematic risks.

Types of unsystematic risks

Unsystematic risks occur as two types:

• Business risk. Business risk includes the internal factors that affect a company’s revenue and performance. Business risks can also result from company-specific external factors, such as the government banning a raw material that a company uses.
• Financial risk. Financial risk relates to a company’s debt and equity. If a company takes on too much debt, its debt-to-equity ratio may suffer. A negative debt-to-equity ratio indicates that a company might be on the verge of bankruptcy.

One example of business risk is a major product recall. In 2022, Abbott Laboratories faced a significant business risk when it had to recall several batches of its infant formula due to contamination concerns. This led to a temporary shutdown of its Michigan plant, causing a nationwide shortage of baby formula in the U.S. and significantly impacting the company's revenue and reputation.

A prime example of financial risk is debt overload. WeWork, the co-working space company, has faced severe financial risk due to its high debt levels and unsustainable business model. In 2022, the company's debt-to-equity ratio was negative, indicating more liabilities than assets. This led to a significant drop in its stock price and eventual bankruptcy filing in November 2023.

The 6 main differences between systematic vs. unsystematic risk

This table is helpful in illustrating the key differences between systematic and unsystematic risks.

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Let’s explain each of the above points:

• Impact. Systematic risks can potentially affect the entire industry and the overall economy, whereas unsystematic risks generally affect an organization. Systematic risks are non-diversifiable, whereas unsystematic risks are diversifiable.
• Nature. Systematic risks are unavoidable and uncontrollable, whereas unsystematic risks are avoidable and controllable.
• Factors. Systematic risks result from external factors that occur at a macroeconomic level, which is why they’re unavoidable and uncontrollable. In contrast, unsystematic risks result from internal factors occurring within an organization or externally but in a closely related manner to the organization. They’re linked to microeconomic factors and are avoidable and controllable.
• Protection. The effects of systematic risk can be mitigated through proper asset allocation, whereas mitigating unsystematic risk relies on portfolio diversification.
• Avoidability. Systematic risks can’t be avoided; however, unsystematic risks can be mitigated or avoided.
• Types. Systematic risks include interest, inflation, purchasing power, and market risk, whereas unsystematic risks are financial and business-specific risks.

An in-depth example of systematic risk

We can measure the systematic risk of a particular security, fund, or portfolio using its beta coefficient. Beta measures how sensitive a security’s return is compared to the market. A beta coefficient of 1 indicates that your investment’s systematic risk is equivalent to the average systematic risk of the market. A higher beta coefficient means higher systematic risk and vice versa.

Here’s the formula to calculate the expected return on an asset given the risk:

ERi=Rf+βi(ERm-Rf)

• ERi = Expected return of investment
• Rf = Risk-free rate
• βi = Beta of the investment
• (ERm-Rf) = Market risk premium

You can find beta on Capital IQ or use a free beta calculator.

Let’s assume you buy an individual stock currently worth $250 per share that pays a 5% annual dividend. The stock has a beta of 1.5, which means it’s riskier than the market portfolio.

Now, if the risk-free rate is 3%, and you expect the market to rise by 6% per year, your expected return on the stock would be:

ERi=3%+1.5(6%-3%)=7.5%

So, the expected return of the stock based on the formula is 7.5%.

An in-depth example of unsystematic risk

You can calculate unsystematic risks using the following formula:

Unsystematic risk=(Systematic variance +Unsystematic variance)-Systematic risk

Unsystematic risk=Total variance-Systematic risk

It’s worth noting that unsystematic risk is the same as unsystematic variance.

For example, if the total variance is 15% and the systematic risk is 7.5%, your unsystematic risk would be:

Unsystematic risk=15%-7.5%=7.5%  

So, the unsystematic risk for the stock is 7.5%.

An in-depth example of unsystematic risk

You can calculate unsystematic risks using the following formula:

Unsystematic risk = Total variance - Systematic risk

Let's expand on this concept with a practical example:

Imagine you're analyzing the stock of a major tech company, TechInnovate Inc. The total variance of TechInnovate's stock price over the past year is 15%, while the systematic risk (market-related risk) is estimated at 7.5%.

Applying our formula (unsystematic risk = 15% - 7.5% = 7.5%) shows that 7.5% of TechInnovate's stock price volatility is due to company-specific factors. These could include:

• Product launch failures or successes
• Changes in company leadership
• Legal issues or regulatory challenges
• Competition shifts

These could have a handful of implications, including:

• Risk assessment. Investors can gauge how much of TechInnovate's risk is unique to the company versus general market risk.
• Diversification potential. Since unsystematic risk can be mitigated through diversification, investors might consider balancing their portfolio with other stocks or assets to reduce this 7.5% risk exposure.
• Investment strategy. Value investors might see opportunity in a high unsystematic risk, believing they can profit if the company-specific issues are resolved.
• Comparison. By calculating this for multiple stocks, investors can compare the company-specific risks across different investments.

Understanding and quantifying unsystematic risk allows investors to make more informed decisions about their portfolio composition and risk management strategies.

13 common examples of systematic and unsystematic risks

When looking at the history of these types of risks, we can find some commonalities to watch out for and avoid.

Systematic risk

Unsystematic risk

Impact on different asset classes

Systematic and unsystematic risks affect various asset classes differently, influencing their performance and investor behavior. While systematic risks tend to impact entire markets or asset classes, unsystematic risks are more specific to individual investments within each class.

Understanding these distinctions is crucial for effective portfolio management and risk mitigation strategies across diverse investment types. Let's discuss how each impacts different types of assets.‍

Stocks

Systematic risks, such as market crashes or economic recessions, typically affect stock prices broadly across entire sectors or the market as a whole. For instance, the 2008 financial crisis led to a widespread decline in stock values across multiple industries.

Conversely, unsystematic risks impact individual stocks more directly. A company scandal, like the Volkswagen emissions controversy in 2015, can cause a significant drop in that specific company's stock price without necessarily affecting the broader automotive sector.

Bonds

Bond prices and yields are particularly sensitive to systematic risks like interest rate changes and inflation. When interest rates rise, existing bond prices typically fall as newer bonds offer higher yields. Inflation risk can erode the real value of fixed bond payments over time.

Unsystematic risks in the bond market often relate to the issuer's creditworthiness. For example, if a company's credit rating is downgraded, its bond prices may fall and yields rise, reflecting the increased risk of default.

Real estate

Systematic risks in real estate often manifest as broader economic factors affecting property values across regions or nationally. Economic downturns can lead to decreased demand and lower property values, while natural disasters might impact entire geographic areas.

Unsystematic risks in real estate are more localized, such as changes in neighborhood desirability, zoning laws, or property-specific issues like structural problems. These factors can significantly affect individual property values without necessarily impacting the broader real estate market.

Other asset classes

Other asset classes also face varying degrees of systematic and unsystematic risks. Commodities are often subject to systematic risks like global economic conditions and geopolitical events, while also facing unsystematic risks related to specific supply and demand factors.

Mutual funds and ETFs, which typically hold diversified portfolios, are generally more exposed to systematic risks affecting their underlying assets but can mitigate unsystematic risks through diversification. However, sector-specific funds may still be vulnerable to unsystematic risks affecting their particular industry focus.

Historical context

The 2008 financial crisis exemplifies systematic risk's widespread impact. Triggered by the subprime mortgage crisis, it caused global stock markets to plummet, with the S&P 500 losing over 50% of its value. The U.S. housing market crashed, with average home prices falling more than 25%. Banking, automotive, and construction industries were hit particularly hard, leading to bailouts and bankruptcies.

Similarly, the COVID-19 pandemic in 2020 caused the fastest stock market decline in history, with the S&P 500 falling 12% in just one day. It disproportionately affected travel, hospitality, and retail sectors while benefiting technology and e-commerce.

Other notable systematic risk events include the 2000 dotcom bubble burst, which devastated tech stocks, and the 1973 oil crisis, which triggered widespread inflation and economic stagnation.

‍Are systematic and unsystematic risk diversifiable?

Diversification can significantly reduce unsystematic risk. It’s unlikely that internal affairs, such as strikes, insolvency, a rise in labor turnover, etc., happen simultaneously in every company across every industry. So, you can reduce your risk by diversifying your portfolio.

On the other hand, some events can affect all businesses simultaneously. External affairs such as inflation, rising unemployment, and fluctuating interest rates influence the entire economy, not just a specific company or industry.

In those cases, diversification can’t eliminate the risk. These systematic risks are known as non-diversifiable risks, and they account for most of the risks in a well-diversified portfolio.

Hedging systematic and unsystematic risks of assets and investments

Systematic risks, while not eliminable through diversification, can be managed through sophisticated hedging techniques and financial instruments.

One common approach is using derivatives such as futures, options, and swaps to offset potential losses. For example, an investor holding a large stock portfolio might purchase put options on a broad market index to protect against a market-wide downturn.

Another advanced technique is cross-hedging, which involves using instruments in one market to hedge risks in a correlated market.

For instance, an airline might hedge against rising fuel costs by investing in crude oil futures. Additionally, macro hedging strategies aim to protect against broader economic risks by using instruments like interest rate swaps or currency forwards.

These tools allow investors and businesses to fine-tune their risk exposure across various economic scenarios.

Modern portfolio theory (MPT)

Modern portfolio theory, developed by Harry Markowitz, provides a framework for balancing systematic and unsystematic risks. MPT posits that investors can construct an "efficient frontier" of optimal portfolios offering the highest expected return for a given level of risk.

This theory emphasizes the importance of portfolio diversification to minimize unsystematic risk. By combining assets with different risk profiles and low correlations, MPT aims to reduce portfolio volatility without sacrificing returns.

While it doesn't eliminate systematic risk, MPT helps investors optimize their exposure to it. The theory suggests that beyond a certain point, adding more securities to a portfolio primarily reduces unsystematic risk, leaving the investor with the market's inherent systematic risk.

This insight has led to the development of index funds and ETFs, which offer broad market exposure while minimizing unsystematic risks.

Be smart and monitor risk in your business and investments

Systematic risks can’t be minimized or eliminated like unsystematic risks, but you can effectively protect your business from the impacts of both. Unfortunately, measuring and strategizing ways to handle total risk and volatility can be complex, especially for investors or traders with small portfolios.

To help you monitor and mitigate the effects of financial risks tied to your investments, you may want to hire an independent financial analyst on Upwork. We make it easy to connect to expert talent from across the globe.

Are you a financial analyst looking to help investors and traders with their financial and investment needs? Upwork has many financial analysis jobs available that can help jump-start your career.