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CFA Level I Exam · Portfolio Risk and Return: Part II

Systematic and Nonsystematic Risk Explained for CFA Level I

Updated 7 October 2026 · Fact-checked

Systematic risk is market-wide risk that affects all assets and cannot be diversified away, so investors are paid for bearing it. Nonsystematic risk is specific to a firm or industry and can be diversified away, so it earns no premium. Total variance = β² × market variance + nonsystematic variance.

Understand Systematic and Nonsystematic Risk

Every asset's return moves for two kinds of reasons. Some reasons hit the whole market: recessions, interest rate changes, inflation shocks, wars. Others hit one company or sector: a product recall, a strike, a lost contract.

Systematic risk (market risk) comes from the first group. It affects all risky assets to some degree. You cannot remove it by holding more securities. Nonsystematic risk (also called unsystematic, idiosyncratic, firm-specific or diversifiable risk) comes from the second group.

Diversification works because firm-specific shocks are not perfectly correlated across companies. When you hold many assets, good news at one firm tends to offset bad news at another. As the number of holdings rises, portfolio risk falls quickly at first, then more slowly. It approaches a floor. That floor is systematic risk, not zero. Adding assets with a correlation below 1 with the portfolio is what reduces risk.

The key pricing idea: because investors can diversify away nonsystematic risk at low cost, the market does not pay a premium for it. Only systematic risk is priced. This is why CAPM links expected return to beta, not to total standard deviation.

The market model splits an asset's return as Ri = αi + βi × Rm + ei. The βi × Rm part is systematic. The error term ei is nonsystematic. Because ei is uncorrelated with the market, the variances add up.

Key formulas to remember

Total risk decomposition
Total risk = Systematic risk + Nonsystematic risk
Systematic risk cannot be diversified away. Nonsystematic risk can.
Market model
Ri = αi + βi × Rm + ei
ei is the firm-specific return with zero expected value and zero correlation with Rm.
Variance decomposition
σi² = βi² × σm² + σe²
Systematic variance is βi² × σm². Nonsystematic variance is σe². Variances add, standard deviations do not.
Proportion of systematic risk
R² = βi² × σm² ÷ σi² = ρ(i,m)²
R² is the share of total variance that is systematic.
Beta
βi = Cov(Ri, Rm) ÷ σm² = ρ(i,m) × σi ÷ σm
Measures sensitivity to market moves.
Equal-weighted portfolio variance
σp² = (1 ÷ n) × avg variance + ((n − 1) ÷ n) × avg covariance
As n grows, the first term shrinks toward zero and the average covariance remains.

How to solve Systematic and Nonsystematic Risk questions

Use this approach for any question on systematic and nonsystematic risk.

  1. 1Identify what is being asked: classify a risk, describe diversification, or compute a risk split.
  2. 2For classification, ask: does this event affect the whole market or one firm or industry? Market-wide means systematic.
  3. 3For diversification questions, recall that adding imperfectly correlated assets cuts nonsystematic risk and leaves systematic risk.
  4. 4For numbers, work in variances. Compute systematic variance = β² × σm².
  5. 5Nonsystematic variance = total variance − systematic variance. Take square roots only at the end.
  6. 6Check that the answer fits: the systematic share lies between 0 and 100%, and equals R².
  7. 7For pricing questions, remember only systematic risk earns a risk premium.

Quickest way: Variance split in three moves

When to use it: Any numerical question giving beta, market volatility and total volatility.

  1. Square everything: total σ², market σ².
  2. Systematic = β² × market variance.
  3. Nonsystematic = total − systematic. Compare with the options and pick the one that matches. Eliminate any option larger than total variance.

Common mistakes in Systematic and Nonsystematic Risk

  • Saying a large portfolio has zero risk.

    Students overextend the idea that diversification removes risk.

    Fix: Diversification removes only nonsystematic risk. Systematic risk remains.

  • Adding standard deviations instead of variances.

    The formula looks like a simple sum of two risks.

    Fix: Add variances, then take the square root of the total.

  • Forgetting to square beta.

    Beta is used linearly in CAPM, so students use it linearly here.

    Fix: Systematic variance is β² × σm². In standard deviation terms it is |β| × σm.

  • Believing the market pays for total risk.

    Higher standard deviation feels like it should earn more.

    Fix: Only systematic risk is priced. Nonsystematic risk earns no premium.

  • Classifying an industry-wide shock as systematic.

    It affects many firms, so it looks broad.

    Fix: An industry-specific shock is nonsystematic because you can diversify it by holding firms in other industries. Only shocks that move the entire market are systematic.

  • Confusing R² with the nonsystematic share.

    Both are percentages of variance.

    Fix: R² is the systematic share. Nonsystematic share is 1 − R².

Worked examples

Example 1

A stock has a beta of 1.2. The market's standard deviation is 15% and the stock's total standard deviation is 24%. What is the stock's nonsystematic standard deviation, closest to? A) 9.0% B) 15.9% C) 18.0%

Show the solution
  1. Total variance = 0.24² = 0.0576.
  2. Systematic variance = 1.2² × 0.15² = 1.44 × 0.0225 = 0.0324.
  3. Nonsystematic variance = 0.0576 − 0.0324 = 0.0252.
  4. Nonsystematic standard deviation = √0.0252 ≈ 0.1587, about 15.9%.
  5. Match this to the options: 15.9% is option B.
  6. Option A (9.0%) is a trap. It comes from subtracting the market standard deviation from the total (24% − 15%).
  7. Option C (18.0%) is a trap. It is the stock's systematic standard deviation (1.2 × 15%), not the nonsystematic part.

Answer: B) 15.9%

Example 2

An asset has a correlation of 0.80 with the market. What proportion of its total variance is nonsystematic? A) 20% B) 36% C) 64%

Show the solution
  1. R² = ρ² = 0.80² = 0.64.
  2. Systematic share = 64%.
  3. Nonsystematic share = 1 − 0.64 = 0.36, or 36%.
  4. Option C (64%) is the trap: it is the systematic share.

Answer: B) 36%

Exam tips

  • Read the question for whether it asks for variance or standard deviation, and for systematic or nonsystematic.
  • With three options, eliminate any risk number larger than total risk first.
  • If a question mentions a premium, the answer involves systematic risk only.
  • Expect conceptual items: diversification lowers risk at a decreasing rate, and the floor is market risk.
  • R² and squared correlation are the same thing in the single-index model.

Practice questions from Portfolio Risk and Return: Part II

Systematic and Nonsystematic Risk: frequently asked questions

What is the difference between systematic and unsystematic risk?

Systematic risk affects the whole market and cannot be diversified away. Unsystematic risk is specific to a company or industry and can be removed by diversification. Only systematic risk is rewarded with a risk premium.

How does the number of assets affect portfolio risk?

Adding assets with imperfect correlation lowers portfolio risk, but each new asset helps less than the one before. Risk falls toward a floor set by the average covariance, which is systematic risk.

How is total risk decomposed in the market model?

Total variance equals β² × market variance plus the variance of the error term. The first part is systematic risk. The second is nonsystematic risk.

Why does the market not pay for nonsystematic risk?

Investors can remove it cheaply by diversifying, so no one needs compensation to hold it. Prices therefore reflect only the risk that cannot be diversified.