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The main difference between systematic risk and unsystematic risk is that systematic risk is the probability of a loss associated with the entire market or the segment whereas the unsystematic risk is associated with a specific industry, segment or security.
Systematic Risk vs. Unsystematic Risk
Systematic risk is a consequence of external and uncontrollable variables, which are not business or security specific and strikes the entire market leading to the fluctuation in prices of all the securities. On the other hand, unsystematic risk relates to the risk which emerges out of controlled and known variables, that are industry or security particular. Systematic risk is the risk caused by macro-economic factors within an economy and is above the control of owners or companies. This change causes a fluctuation in the returns earned from risky capitals. Unsystematic risk, on the other hand, is causing by reasons that are within the control of companies such as mismanagement and worker disputes. Both the systematic and unsystematic risk equivalent to total risk. Systematic risk cannot be abolished by the diversity of the portfolio, whereas the diversification proves helpful in avoiding unsystematic risk.
What is Systematic Risk?
Systematic risk is the hazard innate to the entire market or market segment. Systematic risk, also familiar as “undistributed risk,” “volatility” or “market risk,” strikes the overall market, not just a particular inventory or industry. This type of risk is both uncertain and impossible to completely avoid. It cannot reduce through diversification, only through hedging or by using the correct asset allocation strategy. Systematic risk contains all of the unforeseen events that occur in everyday life which are above the control of investors. Systematic risk comprised of the “unknown unknowns” that happen as a result of everyday life. It only avoided by staying away from all risky investments. Systematic risk also thought of as the opportunity cost of putting money at risk. These risks apply to all the zones but controlled. If there is a declaration or event which impacts the entire stock market, a consistent reaction will flow in which is a systematic risk. All investments or securities are subject to systematic risk, and therefore, it is a non-diversifiable risk. Systematic risk cannot be varied away by holding a large number of securities. Systematic risk includes
- Market Risk: Market Risk caused by the herd mentality of investors, i.e., the inclination of investors to follow the direction of the market. Hence, market risk is the trend of security prices to move together.
- Interest Rate Risk: Interest Rate Risk comes up due to variations in market interest rates. In the stock market, this mainly affects fixed income securities because bond prices are inversely related to the market interest rate.
- Purchasing Power Risk: Purchasing power risk arises due to inflation. Inflation is a strong and sustained increase in the common price level. Inflation erodes the purchasing power of money, i.e., the same amount of money can buy fewer products and services due to an increase in prices.
- Exchange Rate Risk: It is the uncertainty associated with changes in the value of foreign currencies.
What is Unsystematic Risk?
Unsystematic Risk is a business or firm-specific threat in each kind of investment. It is also well-known as “Specific Risk” “Diversify Risk” or “Residual Risk.” These are risks which are in effect but are unplanned and can occur at any point of causing widespread disruption. Unsystematic risk described as the uncertainty inherent in a company or industry investment. Types of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, and a product recall. Thus unsystematic risk can be reduced, but the systematic risk will always be present. Unsystematic risk is a chance that is definite to a business or industry. It has been divided into two categories.
- Business Risk: Risk ingrained to the securities, is the company may or may not perform well. The risk when a company plays below average is known as a business risk.
- Financial Risk: Optionally known as leveraged risk. When there is a turn in the capital structure of the company, it amounts to financial risk.
- A change in standards that impacts one industry.
- The inlet of a new competitor into a market.
- A business is forced to recall one of its products.
- A company is set up to have prepared fraudulent financial statements.
- An alliance targets a company for an employee walkout.
- An overseas expropriate the assets of a specific company.
- Systematic risk means the chance of loss related to the whole market or market segment. Unsystematic risk means risk allied with a particular industry or security.
- Systematic risk comes up due to macroeconomic factors. On the other hand, the unsystematic risk comes up due to the macro-economic factors.
- Systematic risk eliminated through several ways like hedging, asset allocation, As opposed to unsystematic risk that eliminated through portfolio diversification.
- Systematic risk is uncontrolled whereas the unsystematic risk is controllable.
- Systematic risk impacts a large number of securities in the market. Conversely, unsystematic risk impacts securities of a particular company.
- Systematic risk insulated into three categories, i.e., Interest risk, market risk, and purchasing power risk. Unlike unsystematic risk, which divided into two large categories business risk and financial risk.
The allusion of systematic and unsystematic risk is also an immense task. As outside powers are intricate in causing systematic risk, so these are inescapable as well as uncontrollable. Besides, it affects the entire market but reduced through fencing and asset allocation. Since unsystematic risk is caused by internal causes so that it can be easily controlled and avoided, up to a great extent through record variation.