What is the key difference between systematic risk and unsystematic risk?

The key difference between systematic risk and unsystematic risk lies in their scope and impact on investments. Systematic risk, often referred to as market risk, is associated with the overall market's movements and economic factors that affect all securities, such as interest rates, inflation, and geopolitical events. Because these factors influence the market as a whole, systematic risk cannot be eliminated through diversification; it affects all investments in the market regardless of their specific characteristics.

On the other hand, unsystematic risk, also known as specific risk, is unique to a particular company or industry. This type of risk can arise from factors such as management decisions, product recalls, or competitive pressures that do not impact the entire market. Since unsystematic risk pertains to individual entities, it can be reduced or eliminated through diversification—by holding a varied portfolio of investments.

Thus, the distinction is clear: systematic risk affects the entire market, while unsystematic risk is confined to specific companies or sectors. This understanding is vital for investors as they strategize how to manage risks within their portfolios.