5.1.1. Systematic and Unsystematic Risk
Risk is often thought about in terms of an investor’s entire portfolio of investments, rather than in terms of a specific security. A portfolio of investments will be susceptible to two kinds of risk: systematic and unsystematic.
Recall that systematic risk is the risk that the entire market will drop, dragging with it the performance of an individual security or portfolio. Systematic risk is also referred to as market risk. If the performance of a portfolio drops due to systematic risk, it has dropped because the whole market has dropped, not because of the performance of the specific investments within the portfolio.
Unsystematic risk is the risk that the value of specific investments within a portfolio will decline due to factors that are unique to the investments in a portfolio. Investments that are correlated tend to move in the same direction, and their volatility is additive, meaning the volatility risk of each investment is added to the risks of the other correlated investments. Investments that are uncorrelated move randomly with respect to one another and may offset each other’s risk. Investments that are negatively correlated move in opposite directions. The more diversified the portfolio, the less unsystematic risk, because its
