Question

We have studied that assets have two kinds of risk: idiosyncratic (specific to the asset) and systemic (common to all assets). Why is the purpose of separating idiosyncratic risk from systemic risk?

When you purchase an asset, do you consider the idiosyncratic risk from systemic risk? Given that systemic risk can be reduced/eliminated by diversification, how much value do you place on diversification?

Answer 1

Answer:-

There are many types of investing risk.
I believe the ultimate risk is permanently losing your capital. In order to avoid the ultimate risk you need an investment risk management plan. Part of this plan is to understand systematic and unsystematic risk and the most effective approaches to mitigating these risks.

Systemic risk

Systemic risk is risk associated with market returns Common to ALL. This is risk that can be attributed to broad factors. It is risk to your Assets portfolio that cannot be attributed to the specific risk of individual Asset.

Sources of Systemic risk could be macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, wars, etc. Macro factors which influence the direction and volatility of the entire market would be systematic risk.

The Main Reason for Separating Unsystematic ( Idiosyncratic risk ) and Systemic risk was :-

An individual company cannot control systematic risk, It can be partially mitigated by asset allocation.

Owning different asset classes with low correlation can smooth portfolio volatility because asset classes react differently to macroeconomic factors. When some asset categories (i.e. domestic equities, international stocks, bonds, cash, etc.) are increasing others may be falling and vice versa.

Unsystematic ( Idiosyncratic risk ) is Asset specific risk which can be avoided by selection of another asset having low risk profile. It is uncorrelated with stock market returns.
Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk.

Proper diversification can nearly eliminate unsystematic risk1. If an investor owns just one stock or bond and something negative happens to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 30, or 40 individual investments, the damage done to the portfolio is minimized.

The important concept of unsystematic risk is that it is not correlated to market risk and can be nearly eliminated by diversification.

Conculsion :-

So from the above discussion we understand that DIVERSIFICATION which Eliminates Unsystematic risk Is the purpose beacause of which there was a need for separating Systematic and Unsystematic risk.