Lesson 3 of 7 · 12 min
Systematic and nonsystematic risk
Total risk splits into market-wide risk that nobody can diversify away and company-specific risk that diversification removes, so only the market-wide part earns a reward.
In short
- Systematic risk (market, non-diversifiable risk) comes from economy-wide factors: interest rates, inflation, business cycles, political uncertainty, widespread disasters.
- Nonsystematic risk (company-specific, industry-specific, diversifiable, idiosyncratic risk) comes from local events such as a failed product trial or a factory accident.
- Total variance = systematic variance + nonsystematic variance. The sum works for variances, not for standard deviations.
- If diversifiable risk were rewarded, everyone would buy it and diversify it away for free; demand would push its reward to zero. Only systematic risk is priced.
- A risk-free asset has neither kind of risk; the market portfolio has only systematic risk. Risk-averse investors should hold well-diversified portfolios.
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