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Tell apart systematic risk and nonsystematic risk

CFA® Level I · Portfolio Management · Portfolio Risk and Return: Part II · PM.4.b

The idea

Systematic risk is exposure common to the whole market — rates, growth, inflation, policy — and cannot be diversified away because every asset carries some of it. Nonsystematic risk is specific to an individual company or industry and falls rapidly as holdings are added, approaching negligible in a broad portfolio. The pricing consequence is decisive: investors are compensated only for risk they cannot avoid. Bearing nonsystematic risk earns no premium, because anyone could have eliminated it at no cost simply by diversifying.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which risk can be substantially eliminated by diversification?

  1. Systematic riskWhy not: Affects every security at once, which is exactly why adding more of them does not remove it.
  2. Nonsystematic risk — correct
  3. Inflation riskWhy not: A systematic influence, shared across assets, and not something spreading holdings can diversify away.

Company-specific surprises offset one another across many holdings. Market-wide exposure does not, because it affects every holding at once.

A harder one

Why does the market not reward investors for bearing nonsystematic risk?

  1. Because it is too small to measureWhy not: It is frequently the larger share of a single stock's volatility.
  2. Because it is always negativeWhy not: It is variability in both directions, which is what makes it risk in the first place.
  3. Because it can be eliminated free — correct

No premium is required to persuade anyone to bear a risk they can diversify away. A premium exists only where risk is unavoidable.

The hardest tier

An investor holds a single stock with very high total volatility but a beta of 0.6. What expected return does the CAPM assign?

  1. A return based on the beta of 0.6, below the market's, despite the high total volatility — correct
  2. A return above the market's, reflecting the high volatilityWhy not: Total volatility is not priced. The market pays only for the 0.6 of systematic exposure.
  3. The risk-free rate, since the stock is undiversifiedWhy not: The risk-free rate corresponds to a beta of zero. This stock has real market exposure.

The model prices only the systematic component. The investor's undiversified position exposes them to risk the market does not pay for, which is a portfolio construction failure rather than a pricing anomaly.

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