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Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies at any given time. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk. Market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market for stocks and bonds.
Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop.
Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks or bonds we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop.
While diversification does not reduce the systematic risks we just examined, it does reduce the unsystematic risks we will look at now. Unlike systematic risk, unsystematic risk applies to a specific issuer or industry space as opposed to the overall market. For instance, the risk that the EPA will increase regulations on the automobile industry is not system-wide. Rather, it affects only a few issuers and industries and therefore represents an unsystematic risk.
Diversifying a portfolio reduces these specific risks by spreading them among stocks of different issuers operating in different sectors. A diversified stock portfolio holds securities in different issuers that operate in different industry spaces. Microsoft, Toyota, Starbucks, and Wells Fargo operate in unrelated industries. Therefore, the portfolio containing them is more diversified than a portfolio holding positions in Starbucks, McDonald’s, Cheesecake Factory, and Dunkin’ Donuts. These four companies are all in the same industry space—the restaurant space, and so, if the restaurant group declined, the portfolio made up of these would likely drop more than a diversified portfolio would.