FundsIndia Explains – Systematic risk and Unsystematic risk

In our previous posts we discussed volatility and risk and also risk adjusted returns. But what are the types of risks to a portfolio and how do you mitigate them. We’ll discuss this in this article.
Portfolio risks are classified as systematic and unsystematic.

What is systematic risk?
Systematic risk is that risk which leads to variation in returns of the portfolio due to macro-economic and market factors. Some of these factors are changes in interest rates and inflation rates in an economy, or any risk that arises due to the political environment, changes in the government policy or any natural disasters. These factors affect the entire market. For example the equity markets reacted adversely to the latest surgical strike carried out by the Indian army. This,even though India is currently fundamentally exhibiting strong economic growth. Likewise, during the Lehman crisis, equities around the world corrected sharply. From the examples, we can observe that this is a type of risk that the fund managers and investors do not have much control on. In other words, they are market risks.

Having said that, there are means to mitigate this risk though it may not be entirely possible to eliminate it. Effective asset allocation with the right weights between various asset classes such as equity, debt and gold will help reduce this risk to some extent. Therefore, while building a portfolio, your advisor recommends an asset allocated approach.

What is unsystematic risk?
Contrary to systematic risk which is due to macro variables, unsystematic risk is the risk that is specific to a stock or a sector. This arises due to the risk inherent in the business or due to any specific reason attributable to a company. For example, holdings in pharma sector exposes you to unsystematic risks by of sudden cancellation of drug approvals. Typically, many mid and small-cap companies hold this risk.Recently, a court ruling that Noida Toll Bridge cannot collect user fee in an asset where it was collecting toll, is a sudden unsystematic risk that has transpired. While this risk is often mitigated by diligent stock selection and monitoring by fund managers, for investors, diversification across a portfolio of stocks (through mutual funds) and diversifying across market caps (through diversified funds or a holding of large, mid and multi-cap funds) is a good way to reduce this risk.

It is because of these risks that diversification, whether across asset classes or across fund categories is usually recommended.