Principles of Finance/Section 1/Chapter 5/Risk/Risk

Systematic RiskEdit

Systematic risk refers to the portion of risk in a stock that is impossible to avoid, it is also called the market risk, or undiversifiable risk. In the Capital Asset Pricing Model, systematic risk is represented by beta.

E(R_i) = R_f + \beta_{im}(E(R_m) - R_f).\,

Systematic risk is called undiversifiable risk because no matter how many securities are in a portfolio, there will always be some element of risk. This is due to the possibility of macroeconomic factors causing the entire market to decrease in value. Beta is a measure of how sensitive a particular security is to these market conditions. A stock with a high beta is more sensitive to market conditions; and, conversely, a stock with a low beta is less sensitive.

Unsystematic RiskEdit

Unsystematic risk is also called idiosyncratic risk, or diversifiable risk. It represents the risk of a security that is unrelated to the market in general. Unsystematic risk can be reduced by holding a diversified portfolio. A diversified portfolio eliminates the likelihood of one isolated event causing a large decrease in portfolio value.

Risk.jpg

As you can see from the above image, as the number of stocks in a portfolio increase, the amount of unsystematic risk approaches zero. However, it is impossible to remove systematic risk, as it concerns the economy in general.

Last modified on 18 July 2009, at 09:24