Systematic and Non-systematic Risks

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.

Systematic Risk

Investors are exposed to systematic risk by virtue of investing in a market. Systematic risk affects an entire market and is based on market operating conditions or factors such as 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

Non-systematic risk is limited to a particular asset class or security and is a function of the “idiosyncrasies” of a particular asset. Investors can avoid non-systematic risk through portfolio diversification. A diversified portfolio reduces 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 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, an investor would still be compensated for the non-systematic risk that they are no longer exposed to. This scenario would entice investors to keep on increasing non-systematic, diversifiable risk and eventually lead to a zero expected return. This scenario, of course, is not valid and demonstrates that we cannot assume that 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 a 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, an investor’s interest to diversify the non-systematic risk element within a portfolio.

Question

Which statement best describes systematic risk?

A. Systematic risk can be diversified and investors are not compensated for this risk.

B. Systematic risk cannot be diversified and investors are compensated for this risk.

C. Systematic risk can be diversified and investors are not compensated for this risk.

Solution

The correct answer is B.

Systematic risk cannot be diversified. 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.