APT 2: Systematic vs. Idiosyncratic Risk
Systematic risk hits the whole market, like recessions or interest rate changes. Idiosyncratic (unsystematic) risk belongs to one company, like a failed product or a lawsuit. Diversification can wash out idiosyncratic risk, so models like CAPM and APT only reward systematic risk.
What you will learn
- What systematic (market) risk is, with real-world examples
- What idiosyncratic (firm-specific) risk is, with examples
- Why diversification removes one but not the other
- How to split total variance into systematic and idiosyncratic parts
- Why investors are only paid for bearing systematic risk
The formula
- σ_total²
- total variance of the stock's returns
- β² × σ_m²
- systematic variance
- σ_e²
- idiosyncratic (firm-specific) variance
Worked example
A stock has beta 1.2 and a total standard deviation of 35%. The market's standard deviation is 20%. How much of its risk is systematic?
- Total variance = 0.35² = 0.1225
- Systematic variance = 1.2² × 0.20² = 0.0576
- Idiosyncratic variance = 0.1225 − 0.0576 = 0.0649
- Systematic share = 0.0576 ÷ 0.1225 ≈ 47%
Answer: About 47% of the stock's variance is systematic and about 53% is idiosyncratic (rounded).
Common questions
What is the difference between systematic and unsystematic risk?
Systematic risk affects the whole market, such as recessions, inflation and interest rate changes, and cannot be diversified away. Unsystematic risk is specific to one company or industry, such as a product recall or a strike, and can be reduced by holding many stocks.
What is idiosyncratic risk?
Idiosyncratic risk is another name for unsystematic or firm-specific risk. It comes from events that affect one company, such as a CEO leaving, a lawsuit or a failed product launch. In a well-diversified portfolio these surprises largely cancel each other out.
Can diversification eliminate systematic risk?
No. Diversification removes idiosyncratic risk because company-specific surprises offset each other. Systematic risk hits nearly all stocks at once, so adding more stocks does not remove it. Hedging or holding safer assets is needed to reduce it.
Why are investors not compensated for unsystematic risk?
Because investors can remove it cheaply by diversifying. Markets will not pay a premium for risk you could have avoided for free, so required returns in CAPM and APT depend only on exposure to systematic risk.