Learning Outcomes
After completing this article, you will be able to distinguish between systematic and unsystematic risk, explain their significance for investors, and describe how diversification impacts risk. You will understand why only systematic risk is compensated in the market, be able to interpret beta as a risk measure, and relate these concepts to ACCA Financial Management (FM) exam requirements.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand the measurement of risk and return within investments. Your revision should cover:
- The relationship between risk and return in financial investments
- The definitions and differences between systematic and unsystematic risk
- The principle of diversification and the portfolio effect
- How systematic risk is measured (beta) and its role in expected returns
- Application of these concepts within the Capital Asset Pricing Model (CAPM)
- The practical implications for investment appraisal and cost of capital decisions
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
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Which of the following best describes systematic risk?
- Risk that can be reduced through diversification
- Risk unique to a company or sector
- Risk arising from market-wide factors such as recession or inflation
- Risk caused by poor company management
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Which type of risk is eliminated by holding a well-diversified portfolio?
- Systematic risk
- Unsystematic risk
- Total risk
- Financial risk
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How does diversification affect an investor’s exposure to systematic risk?
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Briefly explain what ‘beta’ measures in the context of risk and return.
Introduction
Risk and return are central considerations in financial management and investment appraisal. Investors expect higher returns for taking on greater risk, but not all risk is treated equally in the market. This article explains the two main types of investment risk—systematic and unsystematic—and discusses the impact of each on investment decisions and required returns.
Key Term: risk
The probability that actual investment returns will differ from expected returns, reflecting variability and uncertainty in outcomes.
TYPES OF RISK
Risk for an investor can be separated into two main categories: systematic risk and unsystematic risk.
Systematic Risk
Systematic risk, sometimes called market risk, represents the part of total risk that affects all companies and cannot be eliminated through diversification. Examples include economic recessions, changes in interest rates, or widespread political instability. These factors impact the entire market to some extent.
Key Term: systematic risk
The portion of risk arising from macroeconomic or market-wide events, affecting all securities and not reducible through diversification.
Unsystematic Risk
Unsystematic risk, or specific risk, is unique to a particular company or industry. It can result from management decisions, labor disputes, product recalls, or other company-specific events. Unlike systematic risk, unsystematic risk can be reduced or eliminated by holding a diversified portfolio of investments in different sectors or companies.
Key Term: unsystematic risk
The risk specific to an individual company or industry, such as business or operational risk, which can be reduced through diversification.
The Portfolio Effect
Investors do not need to hold only one share or security. By combining different shares in a portfolio, the unique risks faced by individual companies can offset each other. As more unrelated (or less correlated) securities are added, unsystematic risk falls—eventually becoming negligible with sufficient diversification. However, systematic risk remains, as market-wide events still impact all portfolio holdings.
Worked Example 1.1
An investor holds a single company’s shares and is concerned about possible negative news affecting that company. What happens to this risk if the investor adds shares of 20 different companies from different sectors to their portfolio?
Answer:
As the investor adds more unrelated companies to their portfolio, the unsystematic (company-specific) risk is dramatically reduced. Negative events affecting one company are likely to be offset by positive events in others. With enough diversification, unsystematic risk becomes minimal. However, systematic risk (such as a market downturn) still affects all shares and cannot be eliminated this way.
MEASURING SYSTEMATIC RISK: BETA
Because unsystematic risk can be diversified away, investors in efficient markets expect to be rewarded only for bearing systematic risk. The market requires a higher expected return from securities that are more sensitive to systematic risk.
Key Term: beta
A measure of a security’s sensitivity to market movements; beta quantifies systematic risk relative to the market average (which has a beta of 1).
A beta above 1 means the security is more volatile than the market, while a beta below 1 means it is less volatile. A beta of 0 means the security is risk-free (unaffected by market changes).
Worked Example 1.2
Company A has a beta of 1.5 and Company B has a beta of 0.6. If the stock market falls by 10%, what is the expected approximate change in the value of each company’s shares purely due to systematic risk?
Answer:
- Company A: 1.5 × (-10%) = -15% (expected fall of 15%)
- Company B: 0.6 × (-10%) = -6% (expected fall of 6%) Company A’s shares are more responsive to market swings, so investors would require a higher expected return to compensate for this higher systematic risk.
THE IMPORTANCE FOR INVESTORS
Efficient investors hold diversified portfolios to reduce unsystematic risk. Because only systematic risk remains, investment models such as the Capital Asset Pricing Model (CAPM) use beta to estimate the required return for a security:
- Higher beta → higher required return.
The market does not reward investors for bearing unsystematic risk, as it is considered avoidable through diversification.
Exam Warning
Only systematic risk is priced into the market. If you are asked to explain why unsystematic risk does not affect an investor’s required return, make sure you state that diversification can eliminate it, so the market does not compensate for it.
Summary
Investment risk can be separated into systematic (market) risk and unsystematic (specific) risk. Diversification eliminates unsystematic risk, but systematic risk remains no matter how many assets are held. Investors are only compensated for bearing systematic risk, measured by beta, and this risk is used in models for calculating required returns.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and distinguish between systematic risk and unsystematic risk
- Explain how diversification affects each type of risk
- Describe beta as a measure of systematic risk
- Understand why only systematic risk is rewarded in return expectations
Key Terms and Concepts
- risk
- systematic risk
- unsystematic risk
- beta