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Systematic & Unsystematic Risk: Definition & Examples

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  • 0:02 What Is Risk?
  • 0:56 Unsystematic Risk
  • 3:04 Systematic Risk
  • 4:13 Diversification
  • 5:14 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

In financial markets, risk is an important concept to understand. If you hope to make money, you must risk money. In this lesson, we'll learn the difference between systematic and unsystematic risk, which will help you develop your investing strategy.

What Is Risk?

The Oxford Dictionary defines risk as the exposure to danger, harm, or loss. When we talk about risk in the financial markets, we are using the loss part of that definition, in terms of money we might lose. Risk is not something we can eliminate completely. We can lower it, mitigate it, and otherwise make sure it doesn't define our investments, but there will always be some risk whenever we are seeking to obtain a financial reward.

But, all risk is not the same. Being a savvy investor requires being able to identify different types and causes of risk. This will allow us to develop a plan to actively manage it, and if we do suffer a loss - depending on the type of risk that occurred - we'll have a plan developed, in advance, to manage it. In the stock market, all risk can be classified into one of two categories: systematic or unsystematic.

Unsystematic Risk

Unsystematic risk is associated with each individual stock because of company-specific events and risk. For example, a popular stock that has been volatile is Netflix, or NFLX. NFLX has been as low as $60 and as high as $500, meaning it not only has risen from $60 to $500, but it's dropped back down below $100, only to rise back up!

That kind of volatility is typically specific to a single stock, especially those that are still building their business plan and whose investors are still trying to figure out the best method of valuation. An announcement, such as a new name for their DVD business, deals to include more content from certain networks, and international subscriber growth, are all Netflix-specific stories that have led to Netflix-specific stock increases or decreases. This is the definition of unsystematic risk.

There is nothing an investor can to do avoid the unsystematic risk inherent in any stock they own. They can avoid a high degree of unsystematic risk by not buying that kind of stock, but every stock has some degree of unsystematic risk. In fact, there is even a metric that financial analysts use to determine how much unsystematic risk a stock has.

This metric is called beta and measures how much the stock moves in relation to the broader market. A beta of one means if the S&P 500 increases 1%, the stock will, on average, increase 1%. Essentially, a beta of one means the stock has low unsystematic risk. A beta higher than one means the stock will move more, on average, than the market, and a beta of less than one means the stock will, on average, move less than the market. For example, if a stock has a beta of 2 and the market increases .5%, we could expect that stock to increase 1%. If the stock had a beta of .7 and the stock market dropped by 2%, we could anticipate that stock to drop by 1.4%.

Systematic Risk

Systematic risk is the risk that is simply inherent in the stock market. If there is an event or announcement that impacts the entire stock market so most stocks go down in value, that is a reaction to systematic risk. It doesn't mean anything, specifically, about any individual stock; it just means investors in general are spooked, and there is more selling occurring (which makes prices go down) than buying (which would make prices go up).

Unlike with unsystematic risk, investors can protect themselves against systematic risk. Different types of stocks react differently to different types of systematic events. For example, if there is an announcement that the Federal Reserve is going to increase interest rates, bank stocks might drop lower than industrial stocks. Or, if there is bad news about China's economic growth, which has included a lot of building, transportation and mining stocks may go down more than banking stocks.

So, owning stocks in a number of different companies and industries - a strategy known as diversification - can help protect your portfolio against systematic risk. Let's take a closer look at diversification.

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