What you will learn
- Distinguish systematic from unsystematic risk
- Understand which type diversification can remove
- Explain why only systematic risk is rewarded
- Connect this split to beta and the next lessons
The diversification lesson ended on a crucial point: some risk can be diversified away and some cannot. This lesson makes that split precise, because it is one of the key ideas in finance. It explains why you get paid for taking some risks but not others, and it sets up beta, alpha, and the Sharpe ratio in the lessons ahead.
Systematic and unsystematic risk (Edspira)
A clean breakdown of the two types of risk and how diversification affects each. Focus on why only one type can be diversified away.
The two kinds of risk
Total risk splits into two parts. Unsystematic risk, also called specific, idiosyncratic, or diversifiable risk, is the risk tied to an individual company or industry. A product recall, a management scandal, a factory fire, a failed drug trial: these hit one company and have little to do with the broader market. Systematic risk, also called market or undiversifiable risk, is the risk that affects the entire market at once. A recession, an interest rate shock, a war, a financial crisis: these move almost all assets together. Every asset's total risk is a mix of these two.
Key terms
- Unsystematic risk
- Risk specific to one company or industry, which can be diversified away. Also called specific or idiosyncratic risk.
- Systematic risk
- Market-wide risk that affects nearly all assets at once and cannot be diversified away. Also called market risk.
- Diversifiable risk
- Another name for unsystematic risk, because holding many assets removes it.
Diversification removes only one of them
Here is the key result, and it follows directly from the diversification lesson. As you add more and more unrelated assets to a portfolio, the unsystematic risks tend to cancel out. One company's bad news is offset by another's good news, so the company-specific noise averages away. But no matter how many assets you hold, you cannot escape systematic risk, because in a market-wide event almost everything falls together. So diversification shrinks the unsystematic part toward zero while leaving the systematic part fully intact. A well-diversified portfolio is left holding essentially only systematic, market risk.
What diversification leaves behind
You start with one stock and keep adding more unrelated stocks, ending with a broad portfolio of hundreds. What happens to each type of risk?
- Start with one stock. You are exposed to both its company-specific risk and the overall market risk.
- Add many unrelated stocks. The company-specific surprises increasingly cancel each other out across the holdings.
- End with hundreds. The unsystematic risk has largely vanished, but the systematic market risk remains untouched.
Why it matters: A broadly diversified portfolio still rises and falls with the market. That leftover swing is systematic risk, which no amount of diversification removes.
Why only systematic risk is rewarded
This split leads to one of the deeper ideas in finance. Because unsystematic risk can be eliminated for free simply by diversifying, the market does not reward you for bearing it. If you choose to hold a single undiversified stock and it blows up on company-specific news, that was an avoidable risk you were not compensated for taking. Systematic risk is different. Since no one can diversify it away, investors must be paid to bear it, in the form of higher expected returns. This is the core principle behind the Capital Asset Pricing Model: expected return should depend on an asset's systematic risk, not its total risk. The tool that measures exactly how much systematic risk an asset carries is called beta, which is the subject of the next lesson.
The market pays you for the risk you cannot escape, not the risk you were too lazy to diversify away.
Classify the risk
A pharmaceutical company's stock drops sharply after one of its experimental drugs fails a clinical trial. What kind of risk is this, and can diversification protect against it?
A failed drug trial is unsystematic, company-specific risk. Because it affects only this firm, diversification across many unrelated companies can largely remove it.Systematic vs unsystematic risk in a portfolio (Professor)
Reinforces the split with a portfolio view and how adding assets reduces only the diversifiable part. Good second angle on the same idea.
Match each risk to its features
Explain the reward
In your own words, explain why the market rewards systematic risk with higher expected returns but does not reward unsystematic risk.
Write an answer before comparing it with the model response.
Model answer
Unsystematic risk is specific to individual companies, and it can be eliminated for free just by holding a diversified portfolio, where one company's bad news is offset by another's good news. Because anyone can remove it at no cost, the market does not pay investors extra for bearing it. Systematic risk affects the whole market at once and cannot be diversified away, so every investor is stuck with it no matter what they hold. Since it is unavoidable, investors will only take it on if they are compensated with higher expected returns. That is why expected return should depend on systematic risk, measured by beta, rather than on total risk.
You now know that only systematic risk is rewarded. The next lesson introduces the tool that measures an asset's systematic risk and its excess performance: regression, beta, and alpha.