RiskMetrics - Unique vs. Systemic Risk
- Introduction to Risk
- What is Risk?
- Risk and Opportunity
- Risk Preference
- Risk and Performance
- Importance of Risk
- Market Risk
- Event Risk
- Unique vs. systemic risk
- Sources of Risk
- Why Measure Risk?
- Introducing RiskGrades
- Using RiskGrades
Unique vs. Systemic Risk
Understand how to differentiate between systemic and unique risk
Risk is either unique or systemic. Unique risk is exposure to a particular company, and is sometimes referred to as firm-specific risk. Systemic risk (or systematic risk) is the risk of a portfolio after all unique risk has been diversified away.
Reduce unique risk through diversification
You can minimize unique risk by spreading your investments, and avoiding an over-concentration in any single company, industry, or country. Studies show that reasonable diversification can be achieved with as little as a dozen stocks, and most unique risk can be eliminated with 50 stocks (less than 5% unique risk). Of course, this depends on your particular portfolio composition (e.g., 50 bank stocks are not a diversified portfolio).
When all unique risk is diversified away, investors are left with systemic risk. Systemic risks may arise from common driving factors (for example, economic factors, natural disasters, or war) and can influence the whole market's well being. A broad and diversified stock market index, such as the S&P 500, represents mostly systemic risk. Systemic risk cannot be diversified away (e.g., you cannot significantly reduce your risk by spreading your investments over 1000 stocks instead of 500).
The graph below shows how the unique risk of a portfolio of US equities declines with increasing diversification until all the risk becomes systemic. A RiskGrade of around 100 represents the average systemic risk of a diversified global stock index in normal market conditions.