Risk defines a degree of uncertainty that may come during various stages in an entity's lifecycle. The concept of risk is most prevalent in economics and finance. For businesses or investors, identifying and dealing with risk is crucial. It also helps to understand the differences between the types of risk to understand how to mitigate them.
For investors, the difference between systematic and unsystematic risk is critical to define. These are risks that accompany every financial decision. Therefore, it is crucial to know the differences between both of them.
What is Systematic Risk?
Systematic risk represents the risks that are inherent to the entire market or market segment. It affects all market participants similarly and not just a specific stock or company. Other names for systematic risks are undiversifiable, volatility, or market risk. Systematic risks come from various sources and are unpredictable and inevitable.
Investors can use various strategies to mitigate other types of risks, such as diversification. However, most of these strategies do not work for systematic risk. It is because this risk affects the overall market. However, there are still ways to mitigate these risks. Investors can use strategies, such as asset allocation or hedging, to manage systematic risks.
What is Unsystematic Risk?
Unsystematic risk represents risks that relate to a specific company or industry. This risk is inherent to a particular stock, company, or industry rather than the market as a whole. Other names for unsystematic risk include specific, diversifiable, or residual risk. The unsystematic risk may come from external factors, such as new competitors, or internal factors, such as bad performances.
The most common strategy that investors use to mitigate unsystematic risk is diversification. As unsystematic risks relate to specific investments, investors can construct a diversified portfolio to manage them. Investors can sometimes use various techniques to anticipate or predict unsystematic risks. However, it is not always possible to predict it.
What are the differences between Systematic and Unsystematic Risk?
There are many differences between systematic and unsystematic risk. A few of those differences are as below.
Definition
Systematic risks represent risks that apply to the market as a whole. Unsystematic risks, on the other hand, are risks that are specific to a company or industry.
Nature
Systematic risks are uncontrollable and unpredictable in their nature. Therefore, traditional diversification strategies may not work with systematic risks. However, unsystematic risks are usually controllable and diversifiable.
Measurement
The best measurement of systematic risk is the Beta coefficient. Unsystematic risk, in contrast, does not have a measurement unit. However, investors can calculate these risks by deducting the systematic risk from the total risk.
Sources
Systematic risks come from external sources. These include risks such as interest rate risks, material risks, purchasing power risks, etc. Unsystematic risks may come from internal and external sources. These may consist of financial, business, and operational risks, among others.
Mitigation
As mentioned, the best way to mitigate systematic risk is through asset allocation. However, for unsystematic risk, investors can use diversification to mitigate them.
Conclusion
Systematic and unsystematic risks are critical in finance and investing. Systematic risks represent these risks that apply to the market as a whole. On the other hand, unsystematic risks apply to a specific stock or industry. There are various other differences between both these risks, as mentioned above.
Originally Published Here: Systematic Risk and Unsystematic Risk
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