Question

Explain the difference between systematic risk and unsystematic risk. If you had a portfolio with five stocks and wanted to reduce the systematic risk, would you be able to do so by adding ten more stocks? Explain.

Answer 1

Systematic risk is market risk which will be embedded with the performance of the company because these market risk are uncontrollable in nature because these are the risk beyond the control of the company as these will be arising from operating into the market and these can never be eliminated so market risk cannot be diversified.

UnSystematic risk is firm specific risk and it is a risk associated with performance with particular firm and it can be controlled by firm and it is also diversifiable as it can be diversifiable with the better asset allocation.

Hence, firm specific risk can be diversified, whereas systematic risk can never be diversified.

If I have the portfolio of 5 stocks then even if I would have added 10 more stocks I would not been able to minimise any kind of systematic risk because systematic risk is not diversifiable and this is the risk which is not associated with the firm specific factor and it will be decided by the external factors like inflation and interest rate, so we cannot lower the risk by adding more stocks in case of systematic risk.