Different types of investment risk

Systematic Risk

Systematic risk is a risk that is thought to be almost impossible to avoid, as it comes from factors that affect the whole market.

Macro factors such as inflation, interest rates, political changes make up systematic risk. It’s often known as market risk or undiversifiable risk, as it can’t be reduced through diversification.

Beta is effectively a measure of additional systematic risk, as it captures the excess volatility of a stock or portfolio compared to the systematic risk of a benchmark.

Idiosyncratic Risk

A stock or portfolio’s total risk is made up of systematic risk and idiosyncratic, or unsystematic risk.

We’ve said that it’s difficult to reduce systematic risk, but the idiosyncratic portion is the risk that can be reduced by diversification, as it comprises factors that are specific to that particular stock or portfolio.

For example, we could say that the idiosyncratic risks for a portfolio only containing Apple are things like the supply of semiconductors, the verdicts of any ongoing antitrust cases and its ability to attract streaming customers from Netflix and Amazon. These are factors that can be mitigated by diversifying the portfolio to other tech stocks, stocks from other sectors and stocks in other countries.

If systematic risk is measured using beta, then idiosyncratic risk goes hand in hand with alpha, as it’s all about the risk your portfolio is exposed to by doing something different from the market.