Updated for the 2026-2027 CFA® Level I curriculum.
Every security carries two kinds of risk. One kind moves with the whole market. The other kind is tied to a single company or industry. CFA Level I asks you to tell these apart and explain why only one of them earns a risk premium. This distinction sits at the core of Portfolio Risk and Return: Part II, and it feeds directly into CAPM.
Quick Answer
Systematic risk is market-wide risk that affects nearly all securities and cannot be removed through diversification. Nonsystematic risk (also known as Unsystematic risk) is firm- or industry-specific risk that diversification can reduce or eliminate. This split matters for CFA Level I because diversified investors earn a risk premium only for systematic risk. Nonsystematic risk carries no premium, since an investor can remove it at no cost by holding a broad portfolio.
Feature | Systematic Risk | Nonsystematic Risk |
|---|---|---|
Source | Market-wide factors (rates, inflation, GDP) | Firm- or industry-specific events |
Other names | Market risk, nondiversifiable risk | Unique risk, diversifiable risk, firm-specific risk |
Effect of diversification | Cannot be reduced | Can be reduced, close to eliminated |
Compensation | Investors earn a risk premium | No risk premium |
How it's priced | Measured by beta in CAPM | Not priced separately |
Key Takeaways About Systematic vs Nonsystematic Risk
Total risk on any security splits into a systematic component and a nonsystematic component.
Systematic risk comes from macro factors: interest rates, inflation, GDP growth, geopolitical shocks.
Nonsystematic risk comes from firm-specific events: a lawsuit, a product recall, a labor strike.
Adding more uncorrelated securities to a portfolio drives nonsystematic risk toward zero.
Systematic risk remains even in a fully diversified portfolio; it never reaches zero.
Markets compensate investors for systematic risk only, because nonsystematic risk can be avoided at no cost.
What You Need to Know for CFA Level I
Classify a described risk event as systematic or nonsystematic from a short scenario.
Know the alternate names: nondiversifiable/market risk for systematic, diversifiable/unique/firm-specific for nonsystematic.
Understand that a well-diversified portfolio's total risk converges toward its systematic risk level.
Know that CAPM prices only systematic risk, measured through beta, not total risk.
Recognize that adding securities reduces nonsystematic risk but does not touch systematic risk.
Be ready to explain, in one sentence, why nonsystematic risk earns no premium.
Where This Fits in Portfolio Risk and Return
This concept sits inside Portfolio Risk and Return: Part II. Part I covers standard deviation, covariance, and correlation for combining assets. Part II uses those tools to explain why some risk disappears as you diversify and some does not. That surviving risk is what CAPM later prices.
Systematic Risk: Market-Wide Exposure
Systematic risk comes from forces that hit the entire market at once. No single company can avoid it by changing its own operations.
Common sources:
Source | Example |
|---|---|
Interest rate changes | The central bank raises rates, raising borrowing costs across every sector |
Inflation shocks | Rising input costs squeeze margins economy-wide |
Recession or GDP slowdown | Consumer spending drops across most industries |
Currency devaluation | Import costs rise for companies across the economy |
Geopolitical events | A trade dispute disrupts supply chains broadly |
Because every security has some exposure to these forces, systematic risk survives diversification. It is the risk that remains in the market portfolio.
Nonsystematic Risk: Firm- or Industry-Specific Exposure
Nonsystematic risk comes from events tied to one company or one industry, not the whole market.
Common sources:
Source | Example |
|---|---|
Management decisions | A CEO makes a failed acquisition |
Product issues | A single product line gets recalled |
Legal or regulatory action | A lawsuit targets one company |
Labor disputes | A factory strike halts one firm's output |
Industry-specific shocks | A single industry faces new regulation |
These events do not move the whole market. A diversified investor holding hundreds of other securities barely feels them.
Diversification and Residual Risk
As you add securities with low or negative correlation to each other, firm-specific gains and losses start to offset. One holding's bad quarter gets balanced by another holding's good quarter. This offsetting effect is why nonsystematic risk is also called diversifiable or residual risk.
The relationship follows a clear pattern. Total portfolio risk falls quickly as you add the first 10 to 20 holdings. After that, the curve flattens. Once a portfolio holds enough uncorrelated securities, nearly all that remains is systematic risk. Adding more securities beyond that point barely reduces risk further.
This gives a simple variance decomposition:
Where:
= total variance of returns on security or portfolio
= variance from market-wide factors, does not shrink with diversification
= variance from firm- or industry-specific factors, shrinks toward zero as holdings increase
Total risk has two buckets. One bucket empties as you diversify. The other bucket stays full no matter how many securities you hold.
Why Diversified Investors Aren't Paid for Nonsystematic Risk
Markets compensate investors for risk that cannot be avoided. Nonsystematic risk can be removed at no cost, just by holding a broad portfolio. If an investor could earn a premium for bearing risk that is free to eliminate, every rational investor would hold a concentrated portfolio to collect that premium. That would drive prices until the premium disappeared.
So the market prices only the risk that a diversified investor is stuck holding: systematic risk. This is the foundation CAPM builds on when it uses beta to price expected return. This note stops at the decomposition. For the pricing mechanics, see the CAPM study note.
Worked Example
Scenario: An analyst reviews three news events affecting a diversified equity portfolio.
Event 1: The central bank raises its policy rate by 0.50%, increasing borrowing costs across every sector.
Event 2: Harbor Foods Inc., one holding in the portfolio, recalls a contaminated product line.
Event 3: A drought raises the price of a key grain input, squeezing margins across the entire packaged food industry.
Step 1: Classify each event
Event 1 affects every company through the cost of capital. This is systematic risk.
Event 2 affects only Harbor Foods. This is nonsystematic risk.
Event 3 affects one industry, not the whole market, but it affects more than one firm. This is still nonsystematic risk, because holding companies outside the packaged food industry offsets the impact.
Step 2: Assess diversification impact
Event 1 remains in the portfolio no matter how diversified it is.
Event 2 has little effect on total portfolio risk if the portfolio holds many other names.
Event 3 has little effect on total portfolio risk if the portfolio holds industries beyond packaged food.
Only the interest rate event survives diversification. The recall and the drought are both diversifiable, one at the firm level and one at the industry level. A candidate should recognize that industry-specific risk is still nonsystematic risk from the standpoint of a broadly diversified portfolio.
Common Exam Traps
Calling all economic risk nonsystematic
An industry-wide shock feels specific, but if it only affects one sector while leaving the broader market unaffected, it is still diversifiable by holding other sectors. Reserve "systematic" for factors that hit nearly the entire market.
Assuming diversification eliminates all risk
Diversification drives nonsystematic risk toward zero, but systematic risk never disappears. A well-diversified portfolio still carries market risk.
Expecting compensation for diversifiable risk
Some candidates assume more risk always means a higher expected return. Nonsystematic risk adds volatility without adding expected return, because it can be removed for free.
Confusing systematic risk with total volatility
A stock's standard deviation reflects both systematic and nonsystematic risk. Beta reflects only the systematic portion. Don't treat a high standard deviation as proof of high systematic risk.
Practice Question
An analyst holds a portfolio of 50 stocks spread across 10 industries. A single holding, a regional bank, announces a data breach that affects only its own customers. Which type of risk did the breach create, and what happens to the portfolio's total risk after diversification?
Systematic risk; the portfolio's total risk stays unchanged because systematic risk cannot be diversified away.
Nonsystematic risk; the portfolio's total risk falls because holding many uncorrelated stocks offsets firm-specific shocks.
Nonsystematic risk; the portfolio's total risk falls to zero because the portfolio is well diversified.
Correct Answer: B
The data breach affects one company, not the market. That makes it nonsystematic risk. Holding 50 stocks across 10 industries offsets this kind of firm-specific shock, so total portfolio risk falls. It does not fall to zero, because systematic risk remains.
Option A: Misclassifies the event. A breach limited to one bank's customers is firm-specific, not market-wide, so it is nonsystematic, not systematic.
Option C: Correctly identifies the risk type but overstates the diversification effect. Total risk falls toward the systematic risk floor. It never reaches zero.
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FAQs About Systematic vs Nonsystematic Risk
Is nonsystematic risk the same as diversifiable risk?
Yes. Nonsystematic risk, unique risk, and diversifiable risk all describe the same firm- or industry-specific risk that disappears as you add uncorrelated holdings.
Does CAPM price nonsystematic risk?
No. CAPM prices only systematic risk, measured through beta. Nonsystematic risk gets no risk premium because it can be removed through diversification at no cost.
Can nonsystematic risk ever be fully eliminated?
In practice it approaches zero as the number of uncorrelated holdings grows large, but it is not literally zero. Systematic risk is the only component that remains in a broadly diversified portfolio.