What is the difference between systematic risk and unsystematic risk?

The distinction between systematic risk and unsystematic risk is fundamental in understanding risk management in finance. Systematic risk refers to the risk that affects the entire market or a broad range of assets and is often linked to macroeconomic factors such as interest rates, inflation, and economic downturns. Because it is inherent to the entire market, it cannot be mitigated through diversification – all investments will be impacted to some degree by these factors.

Unsystematic risk, on the other hand, is specific to a particular company or industry, resulting from factors such as management decisions, product recalls, or competitive pressures. Unlike systematic risk, unsystematic risk can be reduced through diversification, as spreading investments across various sectors or companies can help mitigate the negative impact of an event that affects only a particular entity.

The correct answer highlights the essence of these two types of risk, emphasizing that systematic risk is broad and affects the market as a whole, while unsystematic risk is localized and can be managed by investors through diversification strategies.