Compare and contrast systematic risk and unsystematic risk in investment analysis.

In investment analysis, systematic risk and unsystematic risk are two fundamental concepts that help investors understand and manage the risks associated with their portfolios. Here's a detailed comparison and contrast of systematic risk and unsystematic risk:

Systematic Risk:

1. Definition: Systematic risk, also known as market risk or undiversifiable risk, refers to the inherent risk that is associated with the entire market or a particular segment of the market. It cannot be eliminated through diversification because it affects all investments to some degree.

2. Causes: Systematic risk arises from macroeconomic factors and events that impact the overall economy and financial markets. Common sources of systematic risk include economic recessions, interest rate changes, inflation, political instability, natural disasters, and global events like pandemics.

3. Diversification: Systematic risk cannot be eliminated through diversification because it affects all investments simultaneously. Investors can, however, manage systematic risk to some extent by asset allocation and hedging strategies.

4. Examples:
- A global recession that leads to a market-wide decline in stock prices.
- Interest rate hikes by the central bank that affect the entire bond market.

5. Measurement: Beta is a common measure of systematic risk. It indicates how closely an investment's returns move in relation to the overall market's returns. A beta greater than 1 suggests higher sensitivity to market movements, while a beta less than 1 indicates lower sensitivity.

Unsystematic Risk:

1. Definition: Unsystematic risk, also known as specific risk or diversifiable risk, pertains to risks that are unique to a particular company or asset. It can be reduced or eliminated through diversification, spreading investments across different assets or sectors.

2. Causes: Unsystematic risk arises from factors specific to individual companies or industries. Examples include company management, competitive dynamics, regulatory changes, supply chain disruptions, and product recalls.

3. Diversification: Unsystematic risk can be mitigated through diversification. By holding a diversified portfolio of assets with low correlations, investors can reduce their exposure to unsystematic risk. The goal is to eliminate the risk associated with individual assets while retaining exposure to systematic risk.

4. Examples:
- A company-specific event, such as a CEO's sudden resignation, leading to a drop in the company's stock price.
- A sector-specific risk, such as a new regulation impacting the pharmaceutical industry.

5. Measurement: Unsystematic risk can be difficult to measure precisely because it is specific to individual assets or sectors. However, portfolio diversification can effectively reduce or eliminate unsystematic risk.

Comparison and Contrast:

1. Nature of Risk:
- Systematic risk is inherent to the overall market or a particular segment of the market.
- Unsystematic risk is specific to individual assets or sectors.

2. Diversification:
- Systematic risk cannot be eliminated through diversification.
- Unsystematic risk can be reduced or eliminated through diversification.

3. Causes:
- Systematic risk is driven by macroeconomic and market-wide factors.
- Unsystematic risk arises from company-specific or sector-specific events.

4. Measurement:
- Systematic risk is often measured using beta.
- Unsystematic risk is challenging to measure precisely but can be managed through diversification.

5. Impact on Portfolios:
- Systematic risk affects all investments simultaneously and cannot be avoided.
- Unsystematic risk impacts individual assets or sectors, but its impact can be reduced through diversification.

In summary, systematic risk is the broad market risk that affects all investments, while unsystematic risk is the specific risk associated with individual assets or sectors. Investors aim to diversify their portfolios to mitigate unsystematic risk while recognizing that systematic risk is an inherent part of investing. A well-diversified portfolio seeks to strike a balance between managing unsystematic risk and maintaining exposure to systematic risk.