In finance, risk can generally be classified into two types, systematic risk and unsystematic risk.
Systematic risk refers to the risk that affects the overall market or a specific market segment, and is therefore unavoidable. It is also known as market risk, economy-wide risk, or non-diversifiable risk. This kind of risk cannot be reduced through diversification because it is inherent in the overall market. Systematic risk factors include changes in interest rates, economic growth, and geopolitical events.
Unsystematic risk, on the other hand, refers to the risk that affects a specific company or industry, and can be reduced or eliminated through diversification. It is also known as specific risk or diversifiable risk. Unsystematic risk factors include company-specific events such as a management change, a product recall, or a lawsuit against the company.
For example, if an investor invests in a single stock, they face unsystematic risk because the stock’s return could be affected by factors specific to that company, such as poor management decisions or a decline in demand for its products. However, if the investor also invests in a diversified portfolio of stocks, then the unsystematic risk is reduced because the negative impact of any one company-specific event is spread out across the portfolio.
The distinction between systematic and unsystematic risk is important for investors when making investment decisions. Investors aim to minimize risk through diversification, and by understanding the sources of risk, they can make more informed decisions about the allocation of their investments.