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6.3 Defining Systematic Risk and Unsystematic Risk

Risks can be simply divided into two groups’ one kind of risk which can be diversified and other which can't be diversified. Diversifiable risk also called as Unsystematic Risk can be diversified whereas Systematic risk can't be diversified.

Systematic risk applies to all the securities and portfolio of securities across all sectors. An investor can't reduce the systematic risk of his portfolio by investing in multiple sectors or securities. Having said that it does not mean that unsystematic risk can be totally diversified, researches has shown that extending a portfolio of stocks beyond 30 will not result in any further decrease of unsystematic risk.

The following graph will help us in understanding things better:

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As we can see from the figure that as the number of securities are increased in a portfolio the systematic risk remains constant while the unsystematic risk reduces and then becomes stagnant. As a result the total risk also decreases initially and then it reaches a minimum point very close to the systematic risk.

One important point to note here is that investors are not rewarded for assuming unsystematic risk because it can be eliminated through diversification. Thus investors are rewarded for assuming only systematic risk. This point will be useful in our next topic of discussion.

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