Strategic Financial Management · Portfolio Theory and Practice

Diversification and Types of Risk: Systematic vs Unsystematic

Updated 11 October 2026 · Fact-checked

Total risk has two parts. Unsystematic risk is specific to a firm or industry and can be reduced by diversification. Systematic risk comes from the whole market and cannot be diversified away. To solve questions, compute portfolio variance using weights, standard deviations and correlation. Lower correlation means a larger risk reduction.

Understand Diversification and Types of Risk

Every investment carries total risk, measured by the standard deviation of returns. This total risk has two parts.

Unsystematic risk (also called specific, diversifiable or company-specific risk) comes from events hitting one firm or industry. Examples are a strike, a product recall, a regulatory penalty or a management change. These events are largely independent across firms, so when you hold many securities, good news in one tends to offset bad news in another.

Systematic risk (market or non-diversifiable risk) comes from factors that affect all securities to some degree. Examples are interest rate changes, inflation, recession, exchange rate shocks and political events. Holding more securities does not remove it. It is measured by beta.

Diversification works because of correlation (ρ) between asset returns. If ρ = +1, returns move in perfect step and there is no risk reduction for the portfolio's standard deviation. If ρ is below +1, portfolio risk is less than the weighted average of the individual risks. At ρ = -1, risk can be eliminated entirely with the right weights. Most real stocks have positive but less than 1 correlation, so risk falls as you add securities, but only down to a floor set by market risk.

So as the number of securities rises, total risk falls quickly at first and then flattens. The flat level is systematic risk. This is why the market rewards only systematic risk in CAPM: investors can remove unsystematic risk at no cost, so it earns no extra return.

Key rules to remember

Total risk: Total risk = Systematic risk + Unsystematic risk; Often shown in variance terms: σ² = β²σm² + σ²(e). Unsystematic part is the residual.
Two-asset portfolio variance: σp² = w1²σ1² + w2²σ2² + 2 w1 w2 ρ12 σ1 σ2; Weights w1 + w2 = 1. Standard deviation σp is the square root of this.
Covariance and correlation: Cov12 = ρ12 × σ1 × σ2, so ρ12 = Cov12 ÷ (σ1 σ2); ρ lies between -1 and +1.
Portfolio return: Rp = w1R1 + w2R2; Return is a weighted average. Diversification changes risk, not expected return.
Perfect positive correlation (ρ = +1): σp = w1σ1 + w2σ2; Portfolio risk is just the weighted average. No diversification benefit.
Perfect negative correlation (ρ = -1): σp = |w1σ1 - w2σ2|; zero risk when w1 = σ2 ÷ (σ1 + σ2); Weight of asset 1 that makes risk zero.
Minimum variance weight (two assets): w1 = (σ2² - Cov12) ÷ (σ1² + σ2² - 2 Cov12); Gives the lowest-risk mix of two assets.

How to solve Diversification and Types of Risk questions

Use this method for any numerical or theory question on diversification and risk types.

1Read what is given: standard deviations, weights, and correlation or covariance. Note whether the data is in variance or standard deviation.
2If correlation is given, find covariance as ρ × σ1 × σ2. If covariance is given, use it directly.
3Compute each weighted variance term: w² × σ².
4Add 2 × w1 × w2 × covariance to get portfolio variance.
5Take the square root to get portfolio standard deviation. Compute portfolio return as the weighted average.
6Compare with the weighted average of the individual risks to show the diversification benefit.
7For theory parts, classify each given risk as systematic (market-wide) or unsystematic (firm-specific) and state which one diversification removes.
8State a clear conclusion: lower correlation gives more risk reduction, and systematic risk remains.

Quickest way: Shortcut for two-asset portfolio risk

When to use it: Use when the question asks for portfolio standard deviation at one or two correlation values.

Calculate A = (w1σ1)² + (w2σ2)² once.
Calculate B = 2 × (w1σ1) × (w2σ2). Reuse it for each correlation.
Portfolio variance = A + ρ × B. Change only ρ.
Check: at ρ = 1 the answer must equal w1σ1 + w2σ2. If not, recheck.
Take the square root last.

Common mistakes in Diversification and Types of Risk

Saying diversification removes all risk.
Students remember that risk falls as securities are added and stop there.
Fix: Say it removes only unsystematic risk. Systematic risk stays, except in the special case of ρ = -1 for two assets.
Taking portfolio risk as the weighted average of standard deviations.
Return is a weighted average, so students assume risk is too.
Fix: That holds only when ρ = +1. Otherwise use the full variance formula with the covariance term.
Forgetting to square weights and standard deviations, or forgetting the 2 in the covariance term.
Rushing under time pressure.
Fix: Write the formula first, then substitute. Check that ρ = 1 gives the weighted average.
Forgetting the final square root.
Variance is calculated and the working stops.
Fix: Underline whether the question asks for variance or standard deviation before you start.
Classifying inflation or interest rate change as unsystematic risk.
Students confuse 'affects my company' with 'affects only my company'.
Fix: If it hits the whole market, it is systematic. If it hits one firm or sector, it is unsystematic.

Worked examples

Example 1

Security X has a standard deviation of 20% and security Y has 30%. A portfolio has 60% in X and 40% in Y. Find the portfolio standard deviation if the correlation is (a) +1, (b) 0.5, (c) -1.

Show the solution

w1σ1 = 0.6 × 20 = 12; w2σ2 = 0.4 × 30 = 12.
A = 12² + 12² = 144 + 144 = 288.
B = 2 × 12 × 12 = 288.
(a) ρ = 1: variance = 288 + 288 = 576, so σp = 24%. This equals 12 + 12, as expected.
(b) ρ = 0.5: variance = 288 + 0.5 × 288 = 432, so σp = √432 = 20.78% (approx).
(c) ρ = -1: variance = 288 - 288 = 0, so σp = 0%.

Answer: σp = 24% at ρ = +1, about 20.78% at ρ = 0.5, and 0% at ρ = -1. The lower the correlation, the greater the risk reduction.

Example 2

Two stocks have standard deviations of 10% (stock P) and 15% (stock Q). Their correlation is 0.4. Find the weight in P that gives the minimum-variance portfolio, and state its variance.

Show the solution

Cov = 0.4 × 10 × 15 = 60.
σP² = 100; σQ² = 225.
wP = (225 - 60) ÷ (100 + 225 - 2 × 60) = 165 ÷ 205 = 0.8049 (approx).
wQ = 1 - 0.8049 = 0.1951.
Variance = (0.8049)² × 100 + (0.1951)² × 225 + 2 × 0.8049 × 0.1951 × 60.
= 64.80 + 8.56 + 18.84 = 92.20 (approx).
σp = √92.20 = 9.60% (approx).

Answer: Hold about 80.5% in P and 19.5% in Q. The minimum portfolio standard deviation is about 9.6%, which is lower than the 10% of the safer stock alone.

Exam tips

In numerical questions, show the formula, the covariance step and the square root. Marks are given for method even if arithmetic slips.
In MCQs, test the extremes: ρ = +1 gives the weighted average, ρ = -1 can give zero risk.
Always state that only unsystematic risk is diversifiable and beta measures systematic risk.
Give examples when classifying risks: strike or product failure is unsystematic, inflation or interest rate change is systematic.
If the question gives variance, do not square it again. Check the units before substituting.

Practice questions from Portfolio Theory and Practice

Diversification and Types of Risk in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CMA IntermediateTypes of Risk: Systematic and Unsystematic

Diversification and Types of Risk: frequently asked questions

What is the difference between systematic and unsystematic risk?

Systematic risk affects the whole market, such as inflation or interest rate changes, and cannot be removed by diversification. Unsystematic risk is specific to a firm or industry, such as a strike, and can be reduced by holding many securities. Beta measures systematic risk.

How does correlation affect diversification?

The lower the correlation between assets, the more portfolio risk falls below the weighted average of individual risks. At ρ = +1 there is no benefit. At ρ = -1 two assets can be combined to remove risk fully.

Can diversification eliminate all risk?

No. It removes unsystematic risk only. A well-diversified portfolio still carries market risk, which is why returns in CAPM depend on beta.

Why does the market not reward unsystematic risk?

Investors can remove it cheaply by diversifying. Since it can be avoided at no cost, investors are not paid extra return for bearing it.