Question

Types of Risk

Explain the differences between total risk, unsystematic risk, and systematic risk. Identify which risk is measured by standard deviation and which is measured by beta. Please explain indepth.

Answer 1

• Systematic Risk does not have a specific definition but is inherent risk existing in the stock market. These risks are applicable to all the sectors but can be controlled. If there is an announcement or event which impacts the entire stock market, a consistent reaction will flow in which is a systematic risk. For e.g. if Government Bonds are offering a yield of 5% in comparison to the stock market which offers a minimum return of 10%. Suddenly, the government announces an additional tax burden of 1% on stock market transactions, this will be a systematic risk impacting all the stocks and may make the Government bonds more attractive.
• Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is also known as “Specific Risk”, “Diversifiable risk” or “Residual Risk”. These are risks which are existing but are unplanned and can occur at any point of causing widespread disruption. For e.g. if the staff of the airline industry goes on an indefinite strike, then this will cause risk to the shares of the airlines industry and fall in the prices of the stock impacting this industry.

One should keep in mind the below formula which in a nutshell highlights the importance of these 2 types of risks faced by all kinds of investors:

The above risks cannot be avoided but the impact can be limited with the help of diversification of shares into different sectors for balancing the negative effects.

Beta measures the risk investors are compensated for,i.e., Systematic risk, while standard deviation measures both systematic and unsystematic risk.