UNSYSTEMATIC AND SYSTEMATIC RISK

Unsystematic risk (also called diversifiable risk) is risk that is specific to a company.

This type of risk could include dramatic events such as a strike, a natural disaster such as a fire, or something as simple as slumping sales.

Two common sources of unsystematic risk are business risk and financial risk.

Diversification can eliminate unsystematic risk from a portfolio. It is unlikely that events such as the ones listed above would happen in every firm at the same time. Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic risk.

On the other hand, some events can affect all firms at the same time. Events such as inflation, war, and fluctuating interest rates influence the entire economy, not just a specific firm or industry.

Diversification cannot eliminate the risk of facing these events. Therefore, it is considered un-diversifiable risk. This type of risk accounts for most of the risk in a well-diversified portfolio. It is called systematic risk or market risk.

However, the expected returns on their investments can reward investors for enduring systematic risks.

Now let us look at the various options that you have in creating a diversified portfolio. A few of the most common combinations will be covered in the screens that follow.