What is the difference between systematic and unsystematic risk?

The distinction between systematic and unsystematic risk is fundamental in investment practice. Systematic risk, often referred to as market risk, is the risk inherent to the entire market or system. This type of risk includes factors such as economic downturns, interest rate changes, political instability, and natural disasters, all of which can impact all investments across the board. Because it affects the overall market, systematic risk cannot be diversified away, meaning that all investors are somewhat vulnerable to its effects.

On the other hand, unsystematic risk is specific to a particular company or industry. This includes risks related to company-specific events such as management changes, product recalls, or regulatory issues that only affect a single firm or sector. Investors can reduce unsystematic risk through diversification, meaning that they can invest in a variety of stocks or sectors to mitigate the impact of any single event on their overall portfolio.

In summary, the correct understanding is that systematic risk influences the entire market, while unsystematic risk pertains to specific companies or industries. This understanding is essential for effective portfolio management and risk assessment in investment practice.