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

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Systematic Risk[edit]

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 Risk[edit]

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.