Systematic risk
Also written Non-diversifiable risk · Undiversifiable risk
The part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
In plain language
Things go wrong in two different ways.
Some are about one company: a factory burns down, a founder leaves, an order is cancelled, the accounts turn out to be false. Hold thirty shares and these cancel out — one company's disaster is another's windfall.
Others hit everything at once: interest rates rise, a monsoon fails, a global credit market seizes, a war begins. No amount of diversification escapes these, because there is nowhere within the market to hide. That is systematic risk.
How it works
Total risk splits in two, and the split has a direct consequence for what an investor is paid.
Unsystematic risk can be removed for free, simply by holding more names — most of the benefit arrives by about 15 to 25 shares spread across sectors. Because it can be removed at no cost, the market does not compensate anybody for bearing it.
Systematic risk cannot be removed at any price, so it is the only risk that carries a return. This is the entire foundation of CAPM: expected return is a function of beta, which measures systematic risk alone, and standard deviation — total risk — does not appear in the equation at all.
The formula
Total risk = Systematic risk + Unsystematic risk
Systematic component of a share's risk = β × σ(market)
A worked example
An investor holds Rs 50 lakh across four IT services companies and calls it a diversified portfolio. It is not: every holding is exposed to the same rupee-dollar rate, the same US client budgets and the same visa regime.
Say the portfolio's standard deviation is 24% against the Nifty's 16%, with a beta of 1.15.
A company-specific shock. One holding loses its largest client and falls 30%. At a 25% weight that costs the portfolio 7.5%, or Rs 3.75 lakh. Spread the same money across twenty shares in six sectors and the identical event costs 1.5%, or Rs 75,000. The risk was removable, and the investor chose not to remove it.
A market shock. The RBI raises rates unexpectedly and the Nifty falls 12%. At a beta of 1.15 the portfolio is expected to fall 13.8%, or Rs 6.9 lakh — and here the twenty-share portfolio fares no better. There is no arrangement of Indian equities that avoids this loss. That is the difference between the two risks, in rupees.
Why NISM asks about it
Chapter 12 (Fundamentals of Risk and Return) sets out the two components, and the distinction then carries the whole of CAPM. Expect classification questions — you are given events and asked which are systematic — and the conceptual point that diversification cannot reduce systematic risk, which is examined almost every sitting.
Common exam traps
- Classify by cause, not by size. A strike at one company's plant is unsystematic however large the loss; a 25 basis point repo change is systematic however small.
- Diversification reduces unsystematic risk only. Any option claiming it reduces or eliminates systematic risk is wrong.
- Beta measures systematic risk; standard deviation measures total risk. The two are not interchangeable.
- "Systematic" is not "systemic". Systemic risk is the risk of the financial system itself failing — a related idea with a different meaning.
- Twenty shares in one sector is not a diversified portfolio. Correlation is what matters, not the count.
Where this is taught
- Series V-B · Chapter 7: Performance of Mutual Fundsintroduced here
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series V-D · Chapter 10: Risk, Return and Performance of Fundsintroduced here
- Series X-A · Chapter 16: Portfolio Performance Measurement and Evaluationintroduced here
- Series XVII · Chapter 5: Evaluating Fund Performance & Fund Selectionintroduced here
Related terms
- BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Sharpe ratioReturn earned above the risk-free rate divided by standard deviation — how much reward an investment produced for each unit of total risk its holder had to live with.
- Standard deviationA measure of how far returns typically stray from their own average — the standard statistic for total risk, counting company-specific and market-wide causes alike.
- RiskThe possibility that actual returns turn out different from what was expected — measured as the dispersion of returns around their own average, and not the same thing as uncertainty.
- Market riskThe risk of loss from movements in market prices — one named category in a manager's risk framework, alongside credit, liquidity and operational risk, and the one measured with VaR and stress tests.
- Risk premiumThe extra return an investor demands over the nominal risk-free rate as compensation for uncertainty about future cash flows — the last and largest block in the required rate of return.
- Modern Portfolio TheoryMarkowitz's framework for building portfolios on expected return and risk together, in which the co-movement between holdings — not their individual riskiness — decides the risk of the whole.
- Unsystematic riskThe part of an investment's risk that belongs to one company or one issuer — a strike, a fraud, a downgrade — and which diversification can remove, unlike market-wide systematic risk.
- Treynor ratioRisk premium per unit of market risk — the return a scheme earned above the risk-free rate, divided by its beta rather than by its standard deviation.
- Systemic riskThe risk that one participant's default triggers defaults by others until the settlement system itself fails — the domino risk, not the market risk.
- AlphaThe return a fund earned above what its beta and the benchmark say it should have earned — the slice of performance left over once the market has been given credit for its share.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.