Systematic risk is inherent in the overall market and cannot be avoided. Non-systematic risk is limited to a particular asset class or security and can be avoided through appropriate portfolio diversification.
Investors are exposed to systematic risk by virtue of investing in the market. Systematic risk affects the market as a whole and is based on market operating conditions or factors like interest rates, inflation, the business cycle, political uncertainty or natural disaster. There is no way to avoid systematic risk but it can be magnified through the use of leverage.
Non-systematic risk is limited to a particular asset class or security and is a function of the “idiosyncrasies” of a particular asset. Investors are capable of avoiding non-systematic risk through portfolio diversification. A diversified portfolio reduces the exposure or reliance on any one underlying security or asset class.
Pricing of Risk
If an asset has both a systematic and non-systematic risk element to it and we assume that the investor will be compensated through returns for both types of risk, then the rational step would be to diversify away the non-systematic risk by including non-correlated assets. This would minimize and eventually reduce to zero the non-systematic risk leaving only the systematic risk.
However, you would still be compensated for the non-systematic risk that you no longer have exposure to. This scenario would entice investors to keep on increasing non-systematic, diversifiable risk eventually leading to a zero expected return. This scenario, of course, is not valid and demonstrates that we cannot assume the investor will be compensated for non-systematic, diversifiable risk. The correct assumption is that non-systematic, diversifiable risk is not compensated for – no incremental reward is gained for taking on non-systematic risk in an efficient market.
Therefore, only the systematic risk is priced and compensated for while non-systematic risk does not generate any return. It is therefore in investor interests to diversify away the non-systematic risk element within a portfolio.
Which statement best describes systematic risk?
A. Systematic risk can be diversified away and investors are not compensated for this risk
B. Systematic risk cannot be diversified away and investors are compensated for this risk
C. Systematic risk can be diversified away and investors are not compensated for this risk
The correct answer is B.
Systematic risk cannot be diversified away. It is the risk inherent in the market. Investors are compensated for systematic risk whereas they are not compensated for non-systematic, diversifiable risk which they should diversify away.
Reading 53 LOS 53c:
Explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk