What's the difference between systematic and unsystematic risk, and which one can be diversified away?

This is a crucial distinction for CFA Level I — it underpins the entire CAPM framework.

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Systematic risk (also called market risk or non-diversifiable risk):

• Affects the entire market or broad economic sectors
• Examples: interest rate changes, inflation surprises, geopolitical crises, recessions
• Cannot be eliminated through diversification
• Measured by beta (β) in the CAPM
• Investors are compensated for bearing this risk via the equity risk premium

Unsystematic risk (also called firm-specific, idiosyncratic, or diversifiable risk):

• Unique to a specific company or industry
• Examples: a factory fire at Vertex Manufacturing, a patent lawsuit against Pinnacle Pharma, the CEO of Crescent Energy being replaced
• Can be eliminated by holding a diversified portfolio
• Investors are NOT compensated for this risk, because they can eliminate it for free by diversifying

How many stocks to diversify?

Research suggests that holding approximately 25-30 uncorrelated stocks eliminates most unsystematic risk. Beyond that, the marginal benefit of adding more stocks diminishes rapidly. However, the systematic component remains no matter how many assets you hold.

Why it matters for pricing:

The CAPM says: E(R) = Rf + β × [E(Rm) - Rf]

Notice that only beta (systematic risk) determines expected return — not total standard deviation. A stock with high total risk but low beta (because most of its risk is firm-specific) will have a low expected return according to CAPM.

Exam tip: If a question asks about the risk that is "priced" or "rewarded" by the market, the answer is always systematic risk. Unsystematic risk earns no premium because rational investors diversify it away.

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