A deep dive into market-wide versus asset-specific risks, highlighting diversification principles, CAPM beta, and real-world applications.
When we talk about investments, we’re often confronted by the word “risk.” You know, that slightly uncomfortable feeling that something might not pan out as expected. In portfolio theory, “risk” gets a whole lot of attention because it helps investors figure out how uncertain future returns might be. But not all risk is created equal. Some risk is entirely bound to broad economic shifts—think interest rate changes or big moves in the global business cycle—while other risk is specific to just one company (maybe your favorite local pizza chain had a massive cheese shortage) or a single industry (like how oil prices harm or help energy firms).
From a modern portfolio perspective, we split total risk into two big categories: systematic risk and nonsystematic risk. Let’s break that down in a straightforward way.
Total risk is basically the overall ride of ups and downs that a security (or a portfolio) experiences. It can be sliced into:
• Systematic risk (sometimes people call it market risk), and
• Nonsystematic risk (also known as idiosyncratic or unique risk).
Systematic risk embodies the idea that no matter how many stocks or bonds you hold, there are broad factors—like macroeconomic policy, interest rate changes, geopolitical tensions, or inflation—that can affect all investments in one way or another.
• It can’t be diversified away.
• It usually arises from dominant market-wide factors (interest rates, GDP growth, policy shifts).
• It’s measured in many practical models by “beta,” which you’ll see referenced in the Capital Asset Pricing Model (CAPM).
If you’ve ever watched financial news channels and heard them talk about “the market tanked today,” that’s a sign that everyone’s boat floated lower (or higher) on the same tide—systematic risk in action.
Nonsystematic risk, on the other hand, is the stuff that’s unique to a particular firm or a specific industry. It’s your neighbor’s medical device startup that soared or fell after they either got or lost an important FDA approval. Such unexpected wins or setbacks affect that specific company (or maybe a small subset of companies in a sector), rather than the entire stock market.
• You can reduce (or sometimes nearly eliminate) this by owning more assets in different sectors or geographies.
• It’s tied to things like a company’s product strategy, competitive edge, or leadership changes.
• While it can be volatile, it’s the kind of risk we typically consider “avoidable” if you hold a well-diversified portfolio.
If you diversify effectively—say, by owning 40 or 50 different stocks across industries, or by purchasing a broad-based exchange-traded fund (ETF)—most of that unique, nonsystematic volatility is smoothed out. Granted, owning shares in 10 different crypto startups might not help if they’re all vulnerable to the same idiosyncratic factors, so the trick is to diversify across truly different industries or asset classes.
A long time ago, I remember building my very first portfolio on a small investment platform. I thought, “I’ll pick six or seven high-growth stocks,” and was quite proud of my stock analysis. Then, out of nowhere, half of them took a downward turn for separate reasons. I learned fast that if I’d thrown in more positions from multiple industries, my total loss might have been smaller.
Financial theory (and basic common sense) suggests that the more independent holdings you have, the more you spread out that nonsystematic risk. Imagine each individual stock is like a single wave in the ocean—some waves might be bigger, others smaller, but if your boat is riding all the waves at once, your overall experience feels more stable when viewed in total. At an extreme, you can own broad market ETFs that track entire indices (like the S&P 500), and by doing so, theoretically, you eliminate most nonsystematic risk. That’s because the poor performance of any one company can be offset by the better performance of another.
But there’s a caveat: you can’t get rid of the entire ocean’s tide. The ocean here stands for systematic risk—the part that will rise and fall no matter how many securities are in your basket. So, no matter how many stocks or bonds I include, I stay exposed to events such as global recessions, pandemics, or central bank rate decisions.
Now, let’s talk about the Capital Asset Pricing Model (CAPM) for a moment, a topic covered in more depth in another section of this volume. The CAPM is built on the idea that rational investors only get compensated (in terms of higher expected returns) for bearing systematic risk because, in theory, nonsystematic risk can be diversified away.
In the CAPM world, the expected return of an asset is tied to something called “beta,” which is basically a measure of how sensitive the asset is to movements in the overall market. A stock with a beta of 1.5, for instance, is (in theory) more sensitive to broad market swings than another with a beta of 0.8. Investors who take on a higher beta asset might expect a higher return, because they’re more exposed to the market’s gyrations (systematic risk). But they won’t get a special reward for investing in some niche, highly unpredictable, single-stock risk. That part is on them to manage by diversifying.
In CAPM parlance:
E(Rᵢ) = R_f + βᵢ [ E(Rₘ) – R_f ],
where
• E(Rᵢ) is the expected return of portfolio i,
• R_f is the risk-free rate,
• E(Rₘ) is the expected market return,
• βᵢ (beta) measures the sensitivity of security i’s returns relative to the market’s returns.
By focusing on beta, you’re effectively focusing on how the asset’s returns vary with the entire market. The nonsystematic portion gets left out of the equation—again, because from a theoretical standpoint, you’re not supposed to get compensated for that diversifiable risk.
Here’s a simple Mermaid diagram to highlight how these two categories differ and how diversification can mitigate one but not the other.
graph LR
A["Total Risk"] --> B["Systematic Risk <br/>(Market)"]
A["Total Risk"] --> C["Nonsystematic Risk <br/>(Idiosyncratic)"]
B --> D["Cannot be <br/>Diversified Away"]
C --> E["Can be <br/>Diversified Away"]
The broad portion on the left represents total risk. Notice how systematic risk flows into that category we can’t diversify away, while nonsystematic risk flows into that category we can minimize by adding assets from different industries or classes.
You might be wondering what real-life events fuel these two risk categories. Let’s break it down:
• Systematic Risk
– Interest rate shifts (imagine central banks setting or changing policy).
– Economic cycles (recessions, expansions).
– Geopolitical changes (trade wars, big elections, global conflicts).
– Inflation or deflation.
– Natural disasters that slam the entire market sentiment.
• Nonsystematic Risk
– A new competitor emerges, stealing market share from a single firm.
– Company executive scandals or internal mismanagement.
– A product recall or a failed drug trial.
– Labor strikes unique to certain industries.
– Bankruptcy or default specific to one organization.
By capturing both these types of risk, you can see how your total risk is formed. Then you can figure out what portion you can manage or reduce (nonsystematic) and what portion you just accept as part of being “in the market” (systematic).
We often say that if you hold a well-diversified portfolio, you’ll eliminate nonsystematic risk. But let’s be honest—there’s no such thing as perfect diversification. Even index funds are sometimes heavily weighted toward certain sectors or giant companies. Sure, you can hold an S&P 500 index fund, but if the top 10 companies in the index are all information technology giants, your portfolio could still be quite tech heavy.
Furthermore, “unknown correlations” can come into play. Sometimes you expect oil stocks and airline stocks to move in opposite directions (since airlines benefit from cheaper oil), but big macro events can cause them all to crash at once. So, in practice, portfolio managers keep a watchful eye on cross-correlations among asset classes, aiming for a robust spread of truly distinct exposures. The better job you do at that, the more nonsystematic risk you peel away from your portfolio. Yet, you’ll forever be stuck with whatever the broad market does, for better or worse.
While the concept provides a great foundation, we should note some limitations:
• Distinction can be fuzzy in certain crises: Sometimes you see events that appear to affect only a few companies but later spread to an entire sector or the overall economy (like how the subprime mortgage crisis expanded into a broad financial meltdown).
• Beta is not static: Market conditions change, and so does the sensitivity of your investment to those conditions. This can make standard CAPM calculations a bit simplified.
• Diversification cannot always offset sector-wide moves: If your “diversified” portfolio simply invests in multiple tech companies, or invests heavily in correlated asset classes, you might not reduce nonsystematic risk as much as you think.
• Behavioral factors: Investors can exhibit herd behavior or panic selling, causing asset prices to move together unexpectedly.
Even with its challenges, the systematic/nonsystematic concept remains central to how we approach portfolio design. It reminds us that we don’t necessarily earn extra for loading up on random single-stock risk. If you want to manage risk practically, you aim to diversify away most of the idiosyncratic issues so that your portfolio’s risk is primarily systematic.
Portfolio managers typically focus on building broad-based portfolios that deliver the highest possible expected return for a given level of risk. Since systematic risk can’t be eliminated, managers spend a lot of time choosing how much market exposure (beta) to take on. For instance, if a manager wants a less volatile portfolio for clients whose main priority is capital preservation, they might keep a lower beta or tilt more toward fixed income. Conversely, if a manager wants to target higher returns and can tolerate fairly big swings, they might include higher beta equities or more cyclical sectors.
Effective portfolio management doesn’t stop once you buy a well-diversified set of assets. Risks change over time. A company that was once stable might become riskier if it heads into a questionable merger. Global or regional events might cause once-unrelated assets to become closely correlated. That’s why managers continually rebalance portfolios, especially if certain holdings become overweight relative to the initial plan.
Even if your portfolio is well-diversified, it can still take a major hit when broad sentiment sours. Helping clients understand that systematic risk is always lurking in the background builds realistic expectations and prevents overreactions during market downturns.
An interesting (albeit painful) recent example of systematic risk is the pandemic-driven decline that hit financial markets globally around March 2020. Virtually every sector experienced declines simultaneously—travel stocks, retail, energy, you name it. That’s a hallmark of systematic risk: no matter how many different airlines or hotel groups you owned, they were all hammered by the same overarching event.
On the flip side, the technology sector quickly recovered and soared higher as remote work boomed. But within those tech stocks, some niche subsectors fared exceptionally well, reflecting certain unique (nonsystematic) vulnerabilities or strengths. However, in those initial weeks, you couldn’t really hide from the broad market panic. That’s systematic risk at work.
Beyond CAPM, many in the investment world have adopted multi-factor models to get an even more granular understanding of systematic and nonsystematic risk. Instead of just a single market factor, they might include factors such as size, value, momentum, or quality. Under a multi-factor lens, each factor is considered a source of systematic risk if it’s broad enough to affect a wide swath of securities.
But the core principle remains consistent: you can’t diversify away risk that applies to the entire market or to broad systematic factors, but you can reduce the risk that’s quirky or unique to a single stock or sector.
• Best Practices
– Ensure adequate diversification across truly different asset classes, sectors, and geographies.
– Continuously monitor correlations, as they can shift unpredictably.
– Use stress tests and scenario analyses to see how your portfolio might respond to large macro shocks.
– Communicate systematically with stakeholders about expected volatility and set realistic return objectives.
• Potential Pitfalls
– Overconcentration in correlated assets that appear different at first glance.
– Relying solely on historical beta estimates in a dynamic market environment.
– Ignoring liquidity risk, operational risks, or other “hidden” risk factors.
– Assuming that systematic risk always stays at a steady level—it can spike quickly when big news hits.
• Understand the difference between systematic and nonsystematic risk inside-out. CAPM testing and portfolio theory questions almost always revolve around these distinctions.
• Practice with example portfolios, showing how correlation affects nonsystematic risk.
• Be prepared to explain the rationale behind why investors aren’t compensated for nonsystematic risk in the CAPM framework.
• Recognize that real-world complexities (like liquidity constraints, transaction costs, or factor-based strategies) may alter the textbook view, but the underlying fundamental ideas remain the same.
• Litterman, R. (2003). Modern Investment Management: An Equilibrium Approach. Wiley.
• Grinold, R. C., & Kahn, R. N. (2000). Active Portfolio Management: A Quantitative Approach. McGraw-Hill.
• CFA Institute. (Latest Edition). CFA® Program Curriculum.
• For a deeper exploration of multi-factor investing, consider reading various research papers from major asset managers, such as MSCI’s Factor Investing series.
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