United States
Hong KongSystematic and unsystematic risk, and the eight named types
Systematic risk affects the whole market and cannot be diversified away - purchasing power, reinterest rate, market, exchange rate and reinvestment risk. Unsystematic risk is specific to a company or sector and diversification removes it.
One division, two lists, and a measurement rule that follows from it.
The division
Systematic risk affects the market as a whole. You cannot diversify it away, and it is the risk you are compensated for bearing.
Unsystematic risk is specific to a company, industry or country. Diversification removes it, so the market does not pay you to hold it.
That is the entire logic behind CAPM using beta rather than standard deviation.
Systematic risks
| Risk | What it is |
|---|---|
| Purchasing power | Inflation erodes real returns - the risk of holding cash |
| Reinvestment rate | Coupons or maturities reinvested at lower rates |
| Interest rate | Rates rise, existing bond prices fall |
| Market | Broad market movements affecting everything |
| Exchange rate | Currency movements on foreign holdings |
A common mnemonic runs PRIME. Whether you use it or not, the five are the ones to hold.
Unsystematic risks
- Business risk - this company's operations and management.
- Financial risk - this company's leverage.
- Default risk - this issuer failing to pay.
- Political risk - this country's government and policy.
- Regulatory risk - rules affecting this industry.
- Liquidity and marketability risk - the difficulty of selling this holding at a fair price.
Liquidity and marketability are distinguished in some treatments: marketability is whether a market exists, liquidity is whether you can sell quickly without a price concession. Questions occasionally separate them.
A client who moves everything to cash has eliminated market risk and taken on purchasing power risk in full. Over a long horizon that is the greater danger, and questions describing a nervous client want that reasoning rather than reassurance.
Which measure applies
Standard deviation measures total risk - systematic plus unsystematic. Beta measures systematic risk only.
For a well-diversified portfolio the unsystematic component is largely gone, so beta and the Treynor ratio are appropriate. For a concentrated portfolio they are not, and standard deviation and Sharpe are the right tools.
How much diversification
Most unsystematic risk disappears well before a portfolio holds hundreds of securities, and the benefit falls away quickly after the first few dozen.
What matters more is correlation. Twenty holdings in one sector diversify very little, and a question describing a portfolio of twenty technology stocks is asking about that rather than about the number.
Dollar limits and rate thresholds here are indexed annually. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What is the difference between systematic and unsystematic risk?
Systematic risk affects the whole market and cannot be diversified away, so investors are compensated for it. Unsystematic risk is specific to a company or sector and diversification removes it.
What are the systematic risks?
Purchasing power, reinvestment rate, interest rate, market and exchange rate risk. A common mnemonic for the set is PRIME.
Is holding cash risk free?
No. It removes market risk and takes on purchasing power risk in full, which over a long horizon is usually the greater danger.
When should you use beta rather than standard deviation?
For a well-diversified portfolio, where the unsystematic component is largely gone. For a concentrated portfolio, standard deviation and the Sharpe ratio are the appropriate measures.
How many holdings give diversification?
Most unsystematic risk disappears within the first few dozen, but correlation matters more than count. Twenty stocks in one sector diversify very little.