Why Investors Get Paid More for Systematic Risk?

Imagine you are considering investing your hard-earned money. You’ve probably heard that investing involves risk, and it’s true. There’s always a chance that your investments might not perform as expected, or even lose value. Now, when we talk about risk in investing, it’s helpful to understand that not all risks are created equal, and more importantly, not all risks are rewarded in the same way.

Think of risk as falling into two main categories: systematic risk and unsystematic risk. Systematic risk is like a widespread economic event that affects almost every investment out there. Imagine a sudden rise in interest rates from the central bank, or a major global recession. These are events that cast a wide net and impact the entire market, or at least large portions of it. No matter how many different stocks or bonds you own, you can’t completely escape these broad market movements. This type of risk is often referred to as market risk or non-diversifiable risk because it’s inherent to the overall market system.

On the other hand, unsystematic risk is more specific to individual companies or industries. Think about a company suddenly facing a product recall due to safety concerns, or a change in management that investors don’t like, or even just a competitor launching a better product. These events are unique to a particular company or sector. This type of risk is also known as company-specific risk or diversifiable risk.

Now, here’s the crucial point about compensation. Investors, in a rational market, should only expect to be compensated, meaning they should earn a higher return, for taking on risks that they cannot get rid of. Think of it like this: if you can easily avoid a certain type of risk, why should you be paid extra for taking it? That brings us back to systematic and unsystematic risk.

Unsystematic risk, because it’s company-specific, can be significantly reduced, and practically eliminated, by diversification. Diversification is simply spreading your investments across a wide range of different assets. It’s like the old saying about not putting all your eggs in one basket. If you invest in just one company and that company faces trouble, you could lose a lot. But if you invest in many different companies across various industries and even different countries, the impact of any single company’s problems on your overall portfolio is much smaller. In fact, with enough diversification, the impact of unsystematic risk becomes negligible.

Because unsystematic risk can be so easily managed through diversification, the market doesn’t reward investors for bearing it. Why would you get paid extra for taking a risk that you could have easily avoided by simply diversifying your portfolio? It’s like expecting a bonus for crossing the street without looking both ways; it’s a risk you could easily mitigate.

Systematic risk, however, is a different story. Because systematic risk affects the entire market, or large portions of it, diversification within that market cannot eliminate it. No matter how many different stocks you own within a particular stock market, you are still exposed to the overall movements of that market driven by systematic factors like interest rates, inflation, or economic growth. You can’t diversify away the risk of a global recession if you are invested in global stocks.

Therefore, investors should expect to be compensated, through a risk premium, only for bearing systematic risk. This risk premium is the extra return investors demand above a risk-free rate, like the return on government bonds, to compensate them for taking on the unavoidable systematic risk. It’s the price of admission to potentially higher returns in the market. The higher the systematic risk of an investment, the higher the risk premium investors will demand. This is why, in well-functioning markets, the focus for investors should primarily be on understanding and managing systematic risk, as that is the type of risk that truly drives expected returns.