In any stage of life, the risk is the degree of uncertainty. When crossing the road, for example, there is always the chance of being hit by a car if preventative steps are not taken. Similarly, because individuals’ and organizations’ hard-earned money is involved in the cycle, many dangers arise in the area of investment and finance.
We’ll look at the differences between systematic and unsystematic risk in this article. These risks are unavoidable in any financial decision, and one should be prepared to deal with them if they arise.
1. Systematic Risk
The term “systematic risk” may not have a precise definition, but it is a risk that exists in the stock market. These dangers apply to all industries, but they can be managed. If there is a major announcement or event that affects the entire stock market, there will be a predictable reaction. For example, in the context of the big picture, if Government Bonds provide a yield of 5% and the stock market has a minimum return of 10%, Government Bonds are a better investment. Suddenly, the government announces a 1% surcharge on stock market transactions; this will be a systemic risk that will affect all equities and may make government bonds more appealing.
The sources of systematic risks can be:
Political instability or other Governmental decisions having a widespread impact
- Economic crashes and Recession
- Changes in taxation laws
- Natural Disasters
- Foreign Investment Policies
Because systemic risks are inherent and are not always under the control of an individual or a group, they are difficult to minimize. There is no well-defined procedure for dealing with such risks. Still, as an investor, diversification into multiple assets can help to mitigate the impact of unique conditions that might cause a flood of dangers.
2. Unsystematic Risk
Unsystematic Risk is a threat to each type of investment that is industry or firm-specific. “Specific Risk,” “Diversifiable Risk,” and “Residual Risk” are all terms used by the industry people to describe this type of risk. These are hazards that are present but unexpected, and they can occur at any time, causing widespread disruption. For example, if airline employees go on an indefinite strike, the airline industry’s shares will be at risk, and stock prices will decline, negatively harming the industry.
It’s important to remember the following formula, which illustrates the importance of these two categories of risks for all types of investors: Formula for Systematic vs. Unsystematic Risk
Some of the other examples of unsystematic risks are:
- One industry is being impacted by a change in legislation.
- The emergence of a new market competitor.
- A company that has been compelled to recall one of its products (E.g., the Galaxy Note 7 phone recalled by Samsung due to its battery turning flammable).
- An employee union tactic for senior management to meet their demands.
Total risk = systematic risk+unsystematic risk
The above risks cannot be avoided, but their impact can be reduced by diversifying stock holdings across industries to offset negative effects.