NISM-Series-X-A: Investment Adviser (Level 1) · Introduction to Modern Portfolio Theory

Diversification and Types of Risk: Systematic vs Unsystematic

Q: What is the difference between systematic and unsystematic risk?

Systematic risk affects the whole market or economy, such as interest rate changes or recession, and cannot be diversified away. Unsystematic risk is specific to a company or industry and can be reduced by diversification.

Q: How does diversification reduce risk?

When you hold assets that do not move together perfectly, losses on some are partly offset by gains or smaller losses on others. This lowers the swings of the portfolio and cuts unsystematic risk. Market-wide risk remains.

Q: Why does low correlation help diversification?

Low correlation means assets do not rise and fall together, so their movements offset more. At +1 there is no offset. At -1 the offset can be complete with the right weights.

Q: Which risk is measured by beta?

Beta measures systematic risk, which is the sensitivity of a security to market movements. A beta of 1 means it moves with the market on average.

Updated 11 October 2026 · Fact-checked

Total risk has two parts. Unsystematic risk is specific to a company or sector, and diversification can reduce it. Systematic risk comes from the whole market or economy, and diversification cannot remove it. Diversification works best when assets have low or negative correlation. Measure systematic risk with beta.

Understand Diversification and Types of Risk

Every investment can lose value for two kinds of reasons. Some reasons hit one company or industry only: a factory fire, a failed product, a fraud, a regulatory ban on one sector. Other reasons hit almost everything: a rate hike, high inflation, a recession, a global sell-off.

Unsystematic risk (also called specific, diversifiable or idiosyncratic risk) is the first kind. Systematic risk (also called market risk or non-diversifiable risk) is the second kind. Total risk = systematic risk + unsystematic risk.

Diversification means spreading money across many assets. When one holding falls for a company-specific reason, others may rise or stay flat, so the portfolio swings less than a single stock would. As you add more securities, unsystematic risk falls quickly at first and then more slowly. It never fully hits zero in practice, but it can become very small. What remains is systematic risk.

Correlation decides how much help you get. Correlation ranges from -1 to +1. If two assets move in perfect lockstep (+1), mixing them gives no risk reduction. The lower the correlation, the larger the reduction. At -1, risk can in theory be eliminated with the right weights. Holding 20 stocks from the same sector is weak diversification because their correlation is high.

Because the market pays no extra return for risk that you can diversify away, modern portfolio theory says only systematic risk is rewarded. That is why beta, not total standard deviation, is used in CAPM for a security held in a well-diversified portfolio.

Key formulas to remember

Total risk: Total risk = Systematic risk + Unsystematic risk; Systematic is market-wide and non-diversifiable. Unsystematic is specific and diversifiable.
Two-asset portfolio variance: σp² = w1²σ1² + w2²σ2² + 2 w1 w2 ρ12 σ1 σ2; Lower ρ12 gives lower portfolio variance, with weights and σ held the same.
Correlation range: -1 ≤ ρ ≤ +1; At +1 there is no diversification benefit. At -1 risk can be eliminated with suitable weights. Portfolio standard deviation is never above the weighted average of the two standard deviations.
Portfolio standard deviation at perfect correlation: σp = w1σ1 + w2σ2 (when ρ = +1); This is the weighted average. For ρ < +1, σp is lower.
Systematic risk measure: Beta (β) measures sensitivity to market movements; Market beta = 1. Beta above 1 means more volatile than the market.

How to solve Diversification and Types of Risk questions

Use this method for both concept questions and numerical questions on diversification and risk types.

1Read the question and decide what is being asked: type of risk, effect of diversification, or effect of correlation.
2If a risk event is given, ask: does it hit one firm or sector, or the whole market? Firm or sector means unsystematic. Market or economy-wide means systematic.
3Ask whether diversification can remove it. Unsystematic: yes. Systematic: no.
4If correlation is given, place it on the scale from -1 to +1. Lower correlation means greater risk reduction. Correlation of +1 means none.
5For numbers, use the two-asset variance formula. Compute variance first, then take the square root for standard deviation.
6Check the answer: portfolio standard deviation must not exceed the weighted average of individual standard deviations.
7Eliminate options with absolute words such as 'completely removes all risk' unless the correlation is -1 with the exact weights.

Quickest way: Firm or market? Then correlation

When to use it: For one-line conceptual MCQs where you have under a minute.

Firm or sector event: unsystematic, diversifiable. Market-wide event: systematic, not diversifiable.
Choose the answer that says diversification reduces only unsystematic risk.
For correlation, pick the lowest value as giving the largest benefit. -1 beats 0, and 0 beats +0.5.
For a ρ = +1 numerical, use the weighted average of standard deviations. For ρ = 0 or -1, compute the formula.

Common mistakes in Diversification and Types of Risk

Saying diversification removes all risk.
The phrase 'don't put all eggs in one basket' sounds absolute.
Fix: Diversification reduces unsystematic risk only. Systematic risk remains.
Classing a RBI rate hike or an inflation surge as unsystematic risk.
Students link it to one sector such as banks and forget it moves the whole market.
Fix: Ask whether it affects the broad economy or market. If yes, it is systematic.
Thinking more stocks always means better diversification.
Count is easier to see than correlation.
Fix: Many highly correlated stocks, such as ten banking stocks, give limited benefit. Low correlation matters.
Believing the diversification benefit is highest at correlation of 0.
Zero sounds like 'no relationship, so best'.
Fix: The benefit rises as correlation falls, and is greatest at -1.
Taking the weighted average of standard deviations as the portfolio risk in all cases.
Return is a weighted average, so risk is assumed to be too.
Fix: That holds only when ρ = +1. Otherwise use the variance formula, and risk is lower.
Forgetting to take the square root after computing variance.
The formula ends at σp², and the question asks for σp.
Fix: Always check whether the question asks for variance or standard deviation.

Worked examples

Example 1

Asset A has a standard deviation of 20% and Asset B has 10%. A portfolio holds 50% in each. Find the portfolio standard deviation if the correlation is (a) +1 and (b) -1.

Show the solution

Weights: w1 = 0.5, w2 = 0.5. σ1 = 20, σ2 = 10.
(a) With ρ = +1, σp = 0.5 × 20 + 0.5 × 10 = 10 + 5 = 15%.
(b) With ρ = -1, σp² = (0.5×20)² + (0.5×10)² - 2 × (0.5×20) × (0.5×10) = 100 + 25 - 100 = 25.
σp = √25 = 5%.
Check: (b) equals |w1σ1 - w2σ2| = |10 - 5| = 5%, which agrees.

Answer: (a) 15%; (b) 5%. Lower correlation gives lower portfolio risk.

Example 2

Which of the following is an example of systematic risk that cannot be removed by diversification? (A) A key promoter of one listed company is arrested for fraud (B) A strike shuts down one company's plants (C) A sharp rise in interest rates and inflation that lowers valuations across the market (D) A product recall by one pharma company

Show the solution

Test each option: does it affect one firm, or the whole market?
A, B and D each hit one company. They are unsystematic and diversifiable.
C affects the whole market through rates and inflation. It is systematic.
Diversification cannot remove C, so C is the answer.

Answer: (C)

Exam tips

Expect a classification question: give an event and decide systematic or unsystematic. Use the firm-or-market test.
Watch for absolute wording such as 'eliminates all risk'. It is usually the trap option.
Learn the correlation scale: +1 gives no benefit and -1 gives the maximum benefit.
In numerical questions, check whether the answer asked is variance or standard deviation before choosing.
Wrong answers cost 25% of the question's marks in X-A. Skip only if you cannot narrow the options to two.

Practice questions from Introduction to Modern Portfolio Theory

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 FinalDiversification and Types of Risk

Diversification and Types of Risk: frequently asked questions

What is the difference between systematic and unsystematic risk?

Systematic risk affects the whole market or economy, such as interest rate changes or recession, and cannot be diversified away. Unsystematic risk is specific to a company or industry and can be reduced by diversification.

How does diversification reduce risk?

When you hold assets that do not move together perfectly, losses on some are partly offset by gains or smaller losses on others. This lowers the swings of the portfolio and cuts unsystematic risk. Market-wide risk remains.

Why does low correlation help diversification?

Low correlation means assets do not rise and fall together, so their movements offset more. At +1 there is no offset. At -1 the offset can be complete with the right weights.

Which risk is measured by beta?

Beta measures systematic risk, which is the sensitivity of a security to market movements. A beta of 1 means it moves with the market on average.