Every action has the possibility of risks. In the world of business, people often face two kinds of risks, systematic risks and unsystematic risks. Systematic risk is an event that could affect the entire market. In contrast, unsystematic risk affects only one business. Companies need to watch out and prepare themselves for both of these kinds of risks.
This article explores the causes and types of both systematic and unsystematic risks. It also explains how these two risks differ from each other.
Systematic Risk vs Unsystematic Risk
The possibility of a negative future event that can affect the entire market is a systematic risk. Factors external to the economy can cause systematic risk and they are uncontrollable. Different types of systematic risk exist. They are interest risk, market risk and purchasing risk. One way to protect against systematic risk is to engage in asset allocation. To calculate systematic risk, one can use the formula ERi = Rf + (ERm - Rf).
A future negative event that can affect one sector or business is an unsystematic risk. Factors internal to the company cause unsystematic risk. For example, a change in management or company regulations, strikes by employees, etc. These factors make unsystematic risk controllable. Unsystematic risk is of different types, they are business risk and financial risk. To protect oneself against unsystematic risk, one can engage in portfolio diversification. The formula for calculating unsystematic risk is, “unsystematic risk = total variance – systematic risk”.
Difference between Systematic Risk and Unsystematic Risk in Tabular Form
|Parameters of Comparison
|A systematic risk is a negative event that affects the entire market
|An unsystematic risk is a negative event that affects just one market or business
|Nature of risk
|Whom does it affect?
|Interest risk, market risk, purchasing risk
|Business risk, financial risk
|How to protect against the risk
|Companies can protect themselves against systematic risk by engaging in asset allocation
|Companies can protect themselves against unsystematic risk by engaging in portfolio diversification
|ERi = Rf + (ERm - Rf)
|Unsystematic risk=Total Variance-Systematic risk
What is Systematic Risk?
All market sectors contain risks. Risk in the market, which is inherent and unavoidable, is systematic risk. Systematic risk has negative effects on the entire market. All businesses and companies experience the effects of systematic risk. Because of these factors, systematic risk has some other names, “non-diversifiable risk” and “market risk”. Companies cannot limit the negative effects of systematic risk, but they can take certain precautions to protect themselves against future risks.
Causes of systematic risk
Systematic risks happen because of various reasons relating to social, economic and political factors. Some other causes are,
- Unexpected changes made to government policies: changes made to government policies can affect the entire market system.
- Unpredicted natural disasters: natural disasters, whichever kind it comes in, always affect the market.
- Changes made to an entire nation’s economy: Any change made to a nation’s economy causes fluctuations in the market.
- International economic components: A negative effect on the economy on an international level has the potential to bring down the market of nations.
Types of systematic risk
Systematic risk is of many forms. They are as follows,
Fluctuations in interest rates are common in markets. These fluctuations can affect certain assets like bonds and debentures. If the interest rate on these assets goes up, it can cause an enormous negative impact on the borrower. These types of risk arising from the fluctuations of interest rates are "interest risks".
Inflation risk/ Purchasing power risk
When there is a rise in the wages of suppliers and workers, it can affect a firm’s ability to hire them. These changes in wages and cost of production often happen due to inflation in markets. Since these events could happen at any time, they pose a risk to the company. This risk is “inflation risk”; also called purchasing power risk because it affects a company’s ability to purchase goods and services.
While investing in share markets, one can see that the price of shares differs from hour to hour and day to day. However, these may be minor changes. Occasionally the shares will have drastic fluctuations. When investing in a share market or making one's own company public, individuals face the risk associated with share markets. This kind of risk, resulting from the price changes of shares is “market risk”.
Effects of systematic risk
- Systematic risks affect every unit of the population. All business in a country experiences slow sales and financial troubles due to this many people will experience job loss. In addition, the capital inflow may decrease. One nation’s financial troubles can affect other nations. In the end, if countries fail to deal with the risk appropriately, it may even lead to a global slowdown.
Calculating systematic risk
Systematic risk is measurable. Whether it is a security fund or portfolio, companies can use their beta coefficient to calculate an asset’s systematic risk. A beta coefficient can measure a financial asset’s rate of return by comparing it to the rest of the market.
When a security’s beta coefficient is one, it means the asset has an average risk of return when compared to the market.
When a security’s beta coefficient is higher than one, it means that the asset has a high risk of return, compared to the rest of the market.
When a security's beta coefficient is less than one, it means that the asset has a low risk of providing returns compared to the rest of the market.
Formula to calculate a security's expected to return when there is systematic risk:
ERi = Rf + (ERm - Rf)
“ERi” stands for Expected return on investment
“Rf” stands for Risk-free rate
“i” stands for Beta of the investment
(ERm - Rf) stands for the Market risk premium
Why you should analyze systematic risk
- When analysing systematic risk, one analyses the possible risks for the entire economy. This method helps to provide a comprehensive understanding of the entire economy.
- By analysing systematic risk, one can learn about the possible future threats to the economy. Since these unforeseeable events can affect the market as a whole, analysing systematic risk can help investors make informed decisions concerning their stock portfolio.
- Analysing systematic risk can help identify the different possible risks that can affect the economy.
- Analysing systematic risk helps gain insight into the possible repercussions of the risk.
Drawbacks in learning systematic risk
- When analysing systematic risk, one looks at the economy as a whole. It assesses how a possible risk will affect the nation. It does not look at the individual effects of various businesses, stocks, etc. Knowledge about individual sectors can sometimes help get a better understanding of the situation.
- The event of systematic risk produces negative effects on the whole economy. However, the effect may not be the same for every section of the economy. Certain businesses and sectors may suffer more damage than others may. Hence, in these cases, learning about sector-wise effects is more effective than the holistic effects.
What is Unsystematic Risk?
Certain events bring negative effects to only one specific company or area of business. These kinds of risks are unsystematic risks. Some other names of unsystematic risk are non-systematic risk, specific risk, diversifiable risk, and residual risk. Unsystematic risk differs from systematic risk in that a company has a chance to control, minimise and avoid unsystematic risks.
Causes of unsystematic risk
- When a company gets a new competitor working in the same market
- Changes in laws and regulations of a company or nation
- A company being acquired by another
- Change in management within a company
- When companies go through unexpected situations of a product recall
- Strikes by employees, suppliers or the general public
- Negative outcomes of legal proceedings
- Natural disasters
- Shortage of raw material
Different types of unsystematic risks
Unsystematic risk can occur because of many factors and causes. Depending on these factors, there are different kinds of unsystematic risks. Some types of unsystematic risk are as follows,
Running and managing any, company has its risks. Harmful events can happen because of factors within the company and outside the company. Operational factors are one example of internal factors that have the potential to harm the company. If any problem occurs at the managerial or employee level, it can hurt the efficiency of the company. External factors that can harm a company are the actions of other people or institutions. For example, in the case of an international brand, if one country places a ban on your products, it can harm the company’s growth. Hence, both internal and external factors that can hurt a company comprise the business risk.
All companies need an adequate amount of revenue to keep it running and eventually grow. If a company has a weak capital structure, it can affect its revenue. Sometimes, companies end up taking out loans during financial crises. For a company to run smoothly, it requires an optimal level of debt and revenue.
Companies always have a risk of operational functioning going downhill. No matter how hard they try, human beings are prone to errors. They can make mistakes in their forms, they can overlook certain crucial information, or companies may even face a lack of workers. Trouble can come in the form of manufacturing equipment too. Pieces of manufacturing equipment may break down, causing production delays. Companies are also at risk of security breaches. All these problems come under the operational risk of running a business.
Companies can encounter strategic risk in many situations. If you want to run a successful come you need to be able to keep up with the changing world. Sometimes, companies may begin by selling an in-demand product. With the evolution of technologies and equipment, their products can become outdated. If companies do not evolve with the world but instead keep selling the same outdated product, they are facing huge losses.
Another situation in which companies experience strategic risk is flawed partnerships. If a company does not do its necessary research into other firms before entering into partnerships, it can be cheated or end up being partnered with a failing company.
Yet another strategic risk a company faces is when deciding to enter already established markets. For example, a company starting a new brand of automobiles is facing strategic risk. This is because there are several other established brands of automobiles. In addition, people have their personal favourites among these top brands. To grow and earn recognition in such cases will be very difficult.
These situations are all strategic risks a company can encounter.
Legal and regulatory risk
Companies face the risk of negative impacts from changing laws and regulations. Government can pass laws relating to employee welfare, new manufacturing regulations, etc. all of these can have negative effects on a company's growth. Sometimes, governments can ban one of the products completely. If such laws come at a time when companies are done with production, companies will face double losses.
Sometimes a company can break certain rules or laws because of ignorance of the country’s laws. This situation can negatively affect the company’s image and sales.
All these situations are a company’s chances of facing legal and regulatory risks.
Calculating unsystematic risk
While there is no set formula for calculating unsystematic risk, one can make a rough calculation by first calculating systematic risk and then subtracting it from the total risk.
Unsystematic risk=Systematic Variance+Unsystematic variance- Systematic risk
Unsystematic risk=Total Variance-Systematic risk
Main Differences Between Systematic Risk and Unsystematic Risk (in Points)
- Systematic risk is a possible future event that can negatively influence the entire market. Unsystematic risk is a possible negative event that can affect one sector of the economy.
- Systematic risk is uncontrollable; it is not possible to limit the damages. Unsystematic risk is controllable; people can limit the damages incurred.
- Factors external to the economy cause systematic risk for example natural disasters, changing government policies, etc. Internal factors like a change in management or company regulations can cause unsystematic risk.
- Systematic risk affects the entire market. Unsystematic risk affects only one business or sector.
- Different types of systematic risk are interest risk, market risk and purchasing risk. Different types of unsystematic risk are business risk and financial risk.
- Companies can protect themselves against systematic risk by engaging in asset allocation. Portfolio diversification is one method that can help protect against unsystematic risk.
- The formula for calculating systematic risk is ERi = Rf + (ERm - Rf). To calculate unsystematic risk use the formula, unsystematic risk = total variance – systematic risk.
In short, systematic risk and unsystematic risk are both events that can bring harm to the financial sectors. Systematic risk can affect the market as a whole and it is uncontrollable. However, one can try to protect oneself against the risk by engaging in asset allocation. Unsystematic risk only affects one sector of the economy and it is controllable. One way to protect oneself against unsystematic risk is to engage in portfolio diversification.