Systematic vs. Unsystematic Risk
Systematic vs. Unsystematic Risk
Systematic risk (market risk) affects the entire market and cannot be eliminated through diversification, measured by beta. Unsystematic risk (specific or idiosyncratic risk) affects individual securities or sectors and can be reduced or eliminated through diversification. Effective portfolio management focuses on diversifying away unsystematic risk while accepting systematic risk.
During the 2008 financial crisis, the entire market declined (systematic risk) regardless of diversification. However, an investor holding only bank stocks suffered additional losses from bank-specific problems (unsystematic risk), while a diversified investor holding banks, utilities, consumer goods, and bonds reduced those company-specific losses.
Students often confuse which risk type can be diversified away. Unsystematic risk CAN be diversified away (company-specific events), while systematic risk CANNOT (market-wide events). Beta measures systematic risk only, not total risk.
How This Is Tested
- Identifying which risk types can be eliminated through diversification (unsystematic only)
- Understanding that beta measures systematic risk, not unsystematic risk
- Recognizing examples of systematic risk (recession, inflation, interest rate changes) versus unsystematic risk (product recall, management change, lawsuit)
- Determining whether portfolio construction reduces systematic or unsystematic risk
- Understanding that diversification benefits diminish as unsystematic risk approaches zero
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, age 52, is concerned about market volatility and asks his investment adviser representative how diversification will protect his retirement portfolio from losses. The IAR explains that diversification reduces certain types of risk but not others. Which statement most accurately explains what diversification can accomplish for Marcus?
B is correct. Diversification reduces or eliminates unsystematic risk (company-specific events like product recalls, management failures, or lawsuits) by spreading investments across many uncorrelated securities. However, diversification cannot eliminate systematic risk (market-wide events like recessions, inflation, or interest rate changes) that affects all securities simultaneously. Even a perfectly diversified portfolio will decline during a market crash.
A is incorrect because diversification cannot eliminate all risk, only unsystematic risk. Systematic risk remains. C reverses the concepts: diversification reduces unsystematic risk, not systematic risk. Systematic risk affects all securities regardless of correlation. D is incorrect because diversification does not protect against market-wide downturns. all securities tend to decline together during systematic events.
The Series 65 exam tests your ability to set realistic client expectations about diversification. Investment advisers must accurately explain that diversification reduces company-specific risk but cannot protect against market-wide downturns. Misrepresenting diversification as eliminating all risk is a material misstatement.
Which of the following best describes the key difference between systematic and unsystematic risk?
B is correct. Systematic risk (market risk) affects the entire market and all securities within it, caused by macroeconomic factors like recessions, inflation, interest rate changes, or geopolitical events. Unsystematic risk (specific or idiosyncratic risk) affects individual companies or sectors due to company-specific events like management changes, product recalls, lawsuits, or competitive pressures.
A is completely backwards: unsystematic risk CAN be diversified away, while systematic risk CANNOT. This is a fundamental concept in Modern Portfolio Theory. C is incorrect because beta measures systematic risk (not unsystematic), and standard deviation measures total risk (both systematic and unsystematic combined). D is incorrect because both risk types apply to all asset classes, not just stocks.
The Series 65 exam frequently tests the fundamental distinction between systematic and unsystematic risk, particularly which can be diversified away. This is core knowledge for portfolio construction and understanding Modern Portfolio Theory. Confusing these concepts will lead to incorrect answers on multiple exam questions.
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Access Free BetaAn investment adviser is analyzing four recent events that affected client portfolios. Which of the following events represents systematic risk rather than unsystematic risk?
B is correct. Federal Reserve interest rate increases represent systematic risk because they affect the entire market. Rising rates impact all securities by increasing discount rates for future cash flows, making bonds less valuable and equity valuations more challenging. This is a macroeconomic event that cannot be avoided through diversification.
A is unsystematic risk specific to one company. CEO changes affect that individual stock but not the broader market. Diversification across many stocks reduces this risk. C is unsystematic risk specific to one pharmaceutical company. FDA decisions affect individual companies, not the entire market or pharmaceutical sector. D is unsystematic risk specific to one airline. Poor management decisions affect that company, while competitors may benefit.
The Series 65 exam tests your ability to classify real-world events as systematic or unsystematic risk. Understanding this distinction is critical for explaining to clients why their diversified portfolios still experience losses during market-wide events and why diversification cannot eliminate all risk.
All of the following statements about systematic and unsystematic risk are accurate EXCEPT
D is correct (the EXCEPT answer). This statement is FALSE. A well-diversified portfolio can reduce or eliminate unsystematic risk but CANNOT eliminate systematic risk. Even holding all securities in the market index provides no protection against market-wide declines from recessions, inflation, or interest rate changes. Systematic risk is inherent to market participation and cannot be diversified away.
A is accurate: systematic risk (market risk) affects all securities simultaneously through macroeconomic factors and cannot be avoided through diversification. B is accurate: unsystematic risk (company-specific or sector-specific risk) can be reduced or eliminated by spreading investments across many uncorrelated securities. C is accurate: beta specifically measures systematic risk by showing how much a security moves relative to market movements. A beta of 1.0 means the security has average systematic risk.
The Series 65 exam tests whether candidates understand the fundamental limitation of diversification. Investment advisers who claim diversification eliminates all risk are making material misrepresentations. You must accurately explain that diversification addresses unsystematic risk only, while systematic risk remains as the cost of market participation.
A client holds a concentrated portfolio of 5 large-cap technology stocks with a total market value of $400,000. The investment adviser recommends diversifying across multiple sectors and asset classes. Which of the following statements about the current portfolio and proposed diversification are accurate?
1. The current portfolio has high systematic risk due to concentration in one sector
2. Diversifying across sectors will reduce the portfolio's unsystematic risk
3. The portfolio's beta will measure its total risk including both systematic and unsystematic components
4. Even after diversification, the portfolio will still face systematic risk from market-wide events
A is correct. Statements 2 and 4 are accurate.
Statement 1 is FALSE: Sector concentration creates high UNSYSTEMATIC risk, not systematic risk. Technology sector-specific events (regulatory changes, technological disruption) represent unsystematic risk that affects tech stocks specifically. Systematic risk comes from market-wide factors affecting all sectors.
Statement 2 is TRUE: Diversifying across multiple sectors reduces unsystematic risk by ensuring sector-specific events only impact a portion of the portfolio. Technology sector problems would affect a smaller percentage of a diversified portfolio.
Statement 3 is FALSE: Beta measures ONLY systematic risk, not total risk. Beta shows how much a security moves with market movements, which is systematic risk. Standard deviation measures total risk (both systematic and unsystematic combined).
Statement 4 is TRUE: No amount of diversification eliminates systematic risk. Market-wide events like recessions, inflation changes, or interest rate shifts will affect even perfectly diversified portfolios. Systematic risk is inherent to market participation.
The Series 65 exam tests detailed understanding of risk classification and measurement. Investment advisers must correctly identify risk types (systematic vs. unsystematic), understand which can be diversified away, and know which metrics measure each type. This question demonstrates how multiple concepts interact in real portfolio situations.
💡 Memory Aid
Think SYSTEM-atic = SYSTEM-wide: affects the whole system (market) like a power outage hitting all houses. UN-systematic = UN-predictable individual problems: like YOUR house having a leaky roof. You can protect against leaky roofs by owning many houses (diversify away), but a regional power outage hits everyone (can't diversify away). Beta measures the power grid risk, not the roof risk.
Related Concepts
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: