Systematic Risk vs Unsystematic Risk

Summary

This video explains the difference between systemic risk and unsystematic risk in stock investing. Systemic risk refers to market-wide events that impact all companies, such as economic downturns, while unsystematic risk is specific to individual firms, like the retirement of a CEO. Investors can reduce unsystematic risk through diversification, holding a portfolio of varied stocks. The cost of equity for a firm is primarily influenced by systemic risk, as it cannot be diversified away. The concept of beta is introduced as a measure of this systemic risk, setting the stage for further discussions on the capital asset pricing model.

Takeaways

• 😀 Risk refers to the potential deviation of a stock's return from investor expectations.
• 📈 Volatility measures the total risk of a stock, quantified by the standard deviation of its returns.
• 🔍 Unsystematic risk is specific to a single firm, such as events like a CEO's retirement.
• 🌍 Systemic risk affects the overall market, such as economic slowdowns or global events.
• 📊 Diversification allows investors to reduce unsystematic risk by holding a variety of stocks in a portfolio.
• ⚖️ As more stocks are added to a portfolio, firm-specific risks tend to average out, decreasing overall volatility.
• 🛡️ Unsystematic risk is also referred to as diversifiable risk because it can be mitigated through diversification.
• 💰 The cost of equity for a firm is influenced primarily by systemic risk, as unsystematic risk can be diversified away.
• 📉 Systemic risk cannot be eliminated through diversification and is a key factor in determining the risk premium for investments.
• 📏 The concept of beta is used to measure a firm's exposure to systemic risk, which will be explored in future discussions.

Q & A

What is the general definition of risk in the context of stock investing?

Risk refers to the chance that a firm's stock return will deviate from what an investor is expecting.

How is volatility defined in the context of stock returns?

Volatility is the standard deviation of a stock's returns, representing a measure of total risk associated with that stock.

What is the difference between unsystematic risk and systemic risk?

Unsystematic risk is firm-specific and can be eliminated through diversification, while systemic risk affects the entire market and cannot be diversified away.

Can you provide an example of unsystematic risk?

An example of unsystematic risk is the retirement of a company's CEO, which primarily impacts that specific firm.

What kind of events represent systemic risk?

Systemic risk is associated with market-wide events, such as a global economic slowdown that impacts all companies regardless of their individual circumstances.

What is the significance of diversification in managing unsystematic risk?

Diversification allows investors to hold multiple stocks in a portfolio, which averages out firm-specific risks and reduces overall portfolio volatility.

Why is cost of equity associated with systemic risk rather than unsystematic risk?

The cost of equity is influenced by systemic risk because unsystematic risk can be diversified away; hence, only market risk affects the returns required by investors.

What role does beta play in measuring risk?

Beta measures a firm's systemic risk relative to the overall market and is used in the capital asset pricing model (CAPM) to determine the cost of equity.

How does adding more stocks to a portfolio affect its volatility?

As more stocks are added to a portfolio, the overall volatility decreases due to the averaging out of unsystematic risks.

Why do investors need to understand the difference between systemic and unsystematic risk?

Understanding the difference helps investors make informed decisions about portfolio construction and the inherent risks they are taking when investing in individual stocks.