Differences Between Systematic & Unsystematic Risk

Written by diana wicks
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Differences Between Systematic & Unsystematic Risk
Businesses must develop proper structures to insulate themselves from systematic risks as such risks cannot be diversified. (Digital Vision./Photodisc/Getty Images)

Today's business organisations operate in internal and external environments characterised by volatility and uncertainty. These environments expose them to the risk of incurring huge losses. Such risks can be categorised into two categories: systematic and unsystematic risks. Systematic risks are non-diversifiable risks that affect the market or the industry as a whole while unsystematic risks are diversifiable risks that are unique to an organisation.

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Systematic risks are caused by economic crashes, political factors, recessions, natural disasters, changes in taxation and foreign-investment policy. These risks are universal in that they affect any organisation or an investment. Unsystematic risks are created by the strategic, managerial and investment decisions that an individual organisation makes. They can also result from factors such as trade union sanctions, carrying out research and development or the pricing and marketing strategy of a company. Unlike systematic risks, they affect a single business or firms within a specific industry--for instance, how the risk of enactment of harsh tobacco laws may affect cigarette manufacturers.

Risk Minimization

It is difficult to minimise systematic risks as they are brought forth by the prevailing economic conditions or other factors beyond the control of the business management. Unsystematic risks, on the other hand, are minimised by diversifying an organisation's portfolio. This involves investing in shares of companies operating in different industries, or in different asset classes such as stock, bonds, mutual funds or real estate.

Risk Identification

Systematic risks are identified by analysing and estimating the statistical relationships between the various asset portfolios of the organisation using techniques such as principal components analysis. Unsystematic risks are identified using such techniques as threat analysis, insurance policy checklists, organisation charts, financial statements, safety audits and event analysis and a hazard logic tree. These techniques assist managers in appraising their investment portfolios.

Risk handling

Systematic risks have no well-defined handling method as they affect the whole market. Unsystematic risks, on the other hand, can be handled by avoiding a risky project, or preventing a risk from occurring by eliminating the hazards. A hazard such as a weak internal control system can trigger the risk of fraud, which can be prevented by strengthening such a control system. Other techniques of handling unsystematic risks include acceptance--that is, tolerating the risk--or hedging and transfer of the risk to another party such as insurers.

Investment decision.

Investors make different choices on whether to accept or reject various investment options depending on the type of risks such investments carry. In the presence of systematic risks such as inflation, investors will prefer investing in stable and less risky portfolio such as real estate. On the other hand, in the presence of unsystematic risk, investors will diversify by investing in different economic sectors or industries. Losses in one sector are thus erased by gains in another profitable sector.

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