CFA Program Level I

Systematic vs unsystematic risk and diversification: CFA Level I

Systematic (market) risk comes from economy-wide moves and remains however many securities you hold. Unsystematic (firm-specific) risk comes from events at one issuer and shrinks as a portfolio holds more securities that do not move together. The CAPM rewards only systematic risk, because the firm-specific part can be diversified away.

The two kinds of risk

Systematic risk: losses from declines across the markets a portfolio invests in. The SEC's prospectus guide calls this market risk.

Unsystematic risk: the chance that one company goes out of business, has financial problems or underperforms. The SEC's guide calls this business or issuer risk, and notes it is higher for companies without an established record.

Concentration in one industry, sector or region leaves a portfolio less diversified and more volatile.

Total risk = systematic + unsystematic. Beta measures only the systematic part.

How diversification works

For two assets with weights A and B, standard deviations sx and sz, and covariance sxz, the portfolio standard deviation is sqrt(A^2 x sx^2 + B^2 x sz^2 + 2AB x sxz).

The covariance term is the key. The lower it is, the further portfolio risk falls below the weighted average of the two standard deviations. Covariance = correlation x sx x sz.

The SEC's beginners' guide says four or five stocks do not diversify a stock portfolio, and that at least a dozen carefully selected stocks are needed. A total market index fund owns thousands.

Worked example: two assets, 50/50

Asset X: standard deviation 30%. Asset Y: standard deviation 20%. Weights 50% each. The weighted average of the standard deviations is 25%.

Correlation 0.2: covariance = 0.2 x 0.30 x 0.20 = 0.012. Variance = 0.25 x 0.09 + 0.25 x 0.04 + 2 x 0.5 x 0.5 x 0.012 = 0.0225 + 0.0100 + 0.0060 = 0.0385. Standard deviation = 19.62%.

Correlation 1.0: covariance = 0.06. Variance = 0.0225 + 0.0100 + 0.0300 = 0.0625. Standard deviation = 25.00%, the weighted average. With perfect correlation there is no diversification benefit.

Correlation 0: variance = 0.0325, standard deviation = 18.03%.

Why only systematic risk is priced

The CAPM assumes investors can remove firm-specific risk by diversifying, so it pays no extra expected return for bearing it. Expected return depends on beta alone.

So two stocks with the same beta have the same CAPM expected return, even if one is far more volatile because of firm-specific risk.

This is why the Treynor ratio and Jensen's alpha suit diversified portfolios. A poorly diversified portfolio with a low beta but high total risk can look better on them than it is.

Where the exam catches people

Believing more holdings remove all risk: diversification removes firm-specific risk; market risk remains.
Believing a higher standard deviation always means a higher CAPM expected return: only beta, the systematic part, is rewarded.
Believing portfolio standard deviation is the weighted average of the assets' standard deviations: that is true only when correlation is 1.
Believing three stocks from three industries are well diversified: a handful of stocks leaves a lot of issuer risk.
Calling one holding's collapse in a rising market market risk: a single company failing is issuer (unsystematic) risk.

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

Stock X and Stock Y have identical betas. Stock X's return has a standard deviation of 40% and Stock Y's of 25%, and the whole difference in their volatility is firm-specific risk. Under the capital asset pricing model, Stock X's expected return is most likely:
Right. In the game that’s Renown for your Portfolio Construction building.
Not that one: C is right. In the game your Portfolio Construction building would lose a little Renown, and this question would come back later.
Your answerA.Lower than Stock Y'sNothing in the CAPM lowers a stock's expected return for extra firm-specific volatility. With identical betas, the model gives both stocks the same expected return.Your answerB.Higher than Stock Y'sStock X is riskier in total, but its extra risk is nonsystematic, which can be diversified away and is not priced. The CAPM rewards only beta risk, and the two betas are identical.The answerC.The same as Stock Y'sIn the CAPM only systematic (beta) risk is priced: expected return depends on beta alone. Nonsystematic, firm-specific risk can be removed by diversification, so it earns no additional expected return.
Show the full explanation and doc quotes
The two stocks share the same beta, and Stock X's extra volatility is entirely firm-specific, so their CAPM expected returns are equal.
Written from www.cfainstitute.org/insights/professional-learning/refresher-readings/2026/portfolio-risk-return-part-2
A portfolio holds 60% in Asset X, whose return standard deviation is 20%, and 40% in Asset Y, whose return standard deviation is 10%. A reliable estimate of the covariance between the two assets' returns is 0.0050. The portfolio's standard deviation is closest to:
Right. In the game that’s Renown for your Portfolio Construction building.
Not that one: B is right. In the game your Portfolio Construction building would lose a little Renown, and this question would come back later.
Your answerA.12.65%This drops the covariance term 2 × 0.6 × 0.4 × 0.0050 = 0.0024 and takes √(0.0144 + 0.0016) = √0.0160 = 12.65%. With a reliable covariance estimate, the term belongs in the formula and raises the result to 13.56%.The answerB.13.56%For a weighted combination with weights A and B, the standard deviation is √(A²sx² + B²sz² + 2AB·sxz). Here: 0.6² × 0.20² = 0.0144; 0.4² × 0.10² = 0.0016; 2 × 0.6 × 0.4 × 0.0050 = 0.0024. Sum = 0.0184, and √0.0184 = 0.1356, or 13.56%.Your answerC.16.00%This averages the standard deviations by weight: 0.6 × 20% + 0.4 × 10% = 16.00%. The formula combines squared weights, variances and the covariance, then takes the square root, giving 13.56%.
Written from www.itl.nist.gov/div898/handbook/mpc/section5/mpc552.htm
A mutual fund holds shares of 60 companies spread across many industries. During a year in which the broad stock market rises, one holding, a young company with no established record, ceases operations and its shares become worthless. The fund's loss on that holding is best described as an example of:
Right. In the game that’s Renown for your Portfolio Construction building.
Not that one: C is right. In the game your Portfolio Construction building would lose a little Renown, and this question would come back later.
Your answerA.Market riskMarket risk is the chance of loss because the markets the fund invests in decline. The market rose during the year, so this loss came from one company's failure, not the market.Your answerB.Concentration riskConcentration risk arises when a fund focuses on one industry, sector or region and so is less diversified. This fund holds 60 companies across many industries.The answerC.Issuer riskThe SEC's bulletin on reading a mutual fund prospectus describes business or issuer risk as the chance that a company the fund holds goes out of business, has financial problems or underperforms, especially a company without an established record.
Show the full explanation and doc quotes
That is the loss here.
Written from www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/how-read-2