[Series 65] 13, Types of Risk Systematic vs Unsystematic

0:00Today we are covering systematic and unsystematic risk for the Series 65 exam. This distinction is critical because it underpins the core concept of diversification. A topic heavily tested through scenario-based questions. The exam will expect you to identify the type of risk present in a situation and know what can and cannot be done about it. First, let's break down systematic risk. This is the risk inherent to the entire market or market segment. It's non-diversifiable, meaning no matter how many different stocks you own, you cannot escape it. Think of major economic events like a recession, changes in interest rates, or high inflation. These forces affect all boats in the harbor. The primary types of systematic risk you must know are market risk, interest rate risk, and inflation or purchasing power risk. The specific measure for systematic risk is beta.

1:00Beta measures a stock's volatility relative to the overall market. A beta of 1 means the stock moves with the market. A beta greater than 1 means its war volatile than the market. And a beta less than 1 means its less volatile. The exam might test this by stating a stock has a beta of 1.3 and asking for the expected return if the market returns 10%. You would expect a 13% return. On the other side is unsystematic risk. This is the risk that is unique to a specific company or industry. This type of risk is also called business risk or specific risk. The crucial point for the exam is that unsystematic risk is diversifiable. By owning a broad portfolio of stocks across different industries, you can significantly mitigate the impact of a negative event at a single company. For example, if a company's CEO resigns or a factory burns down, the stock will likely fall. But if you own 40 other unrelated stocks,

2:01the impact on your total portfolio is minimized. The two main categories of unsystematic risk are business risk and financial risk. Business risk relates to the company's ability to generate revenue to cover its operating expenses, stemming from factors like competition or poor management. Financial risk is specifically about a company's capital structure and its ability to manage its debt. A company with a high level of debt has high financial risk. A common exam trap is to confuse these two categories. A question might describe an event like a new competitor entering the market and ask what type of risk this represents. This is business risk. A question about a company struggling to make interest payments on its bonds coins to financial risk. Both are unsystematic and can be reduced through diversification. You will not be asked to eliminate market risk through diversification. This is impossible. Here is a simple way to remember the difference.

3:01Systematic is for the system. You can't escape it. Unsystematic is unique to a company. You can diversify it away. Expect a question where a client has a portfolio of 50 different stocks from various sectors. The question will ask which type of risk has been most effectively minimized. The correct answer is unsystematic risk. The portfolio is still fully exposed to systematic risks like interest rate changes and overall market downturns. For free practice questions, AI-powered explanations and more exam prep tools, visit openexamprep.com. That's openexamprepalloneword.com.