Can You Diversify Systematic Risk in Investing

Everyone · Explainer · Updated October 1, 2026 · LearnLife Editorial

What is systematic risk in investing?

Systematic risk is the risk that affects nearly all investments across the market. It originates from factors that influence the overall economy or financial system rather than a specific company or industry. Examples include changes in interest rates, inflation, recessions, political instability, wars, or natural disasters that can disrupt economic activity. Because these risks impact the entire market or large segments of it, they cannot be avoided by simply holding many different stocks or bonds.

This type of risk is sometimes called market risk or undiversifiable risk. It is inherent in investing in the financial markets and impacts stock prices, bond yields, and other asset values simultaneously. For instance, during a recession, most companies’ profits decline, causing a general drop in stock prices. Unlike risks tied to a single company—which can be reduced by spreading your investment across many firms—systematic risk affects all firms to some extent.

Understanding systematic risk helps investors set realistic expectations about the level of risk that cannot be eliminated from their portfolios no matter how diversified they are.

How does systematic risk work? A simple example

To understand systematic risk more clearly, consider a hypothetical investor named Alex who owns stocks in three very different industries: technology, healthcare, and consumer goods. Normally, if the technology sector struggles due to new regulations, healthcare or consumer goods might perform better and offset losses in tech. Alex’s diversified portfolio helps reduce company- or sector-specific risks.

Now suppose a major event occurs, like a sudden increase in interest rates by the Federal Reserve to combat inflation. This makes borrowing more expensive for companies and consumers alike, slowing economic growth. In response, stock prices across all industries, including Alex’s holdings, begin to fall because investors anticipate lower profits and consumer spending.

This broad economic change impacts nearly all sectors simultaneously. Alex’s diversification cannot prevent losses caused by this market-wide event. This demonstrates systematic risk: a risk tied to the entire financial system or economy, not just individual companies.

On the other hand, if a particular company in Alex’s tech portfolio unexpectedly reports poor earnings and its stock price drops, but the rest of the portfolio remains unaffected, this is unsystematic risk, which diversification helps reduce.

Can you diversify systematic risk?

Systematic risk cannot be fully diversified away because it stems from factors that affect the whole market simultaneously. Diversification works by spreading investments across different companies, industries, and sometimes countries to reduce the impact of risks affecting only specific firms or sectors, known as unsystematic risk.

For example, owning shares in both a car manufacturer and a pharmaceutical company helps if one industry faces problems while the other performs well. However, events like changes in government policy, inflation spikes, or global crises affect most companies, making diversification less effective.

That said, while you cannot eliminate systematic risk, you can manage how much of it your portfolio is exposed to. This is done through:

• Asset allocation: Including different types of investments like stocks, bonds, real estate, and cash. Bonds, for example, often react differently to economic changes than stocks.
• Geographic diversification: Investing in foreign markets where economic conditions may vary.
• Alternative investments: Assets like commodities or hedge funds might offer some protection in market downturns.

These strategies don’t remove systematic risk but can reduce portfolio volatility and potential losses during broad market declines.

What is unsystematic risk and why does it matter?

Unsystematic risk, sometimes called idiosyncratic or diversifiable risk, is the risk specific to a single company or industry. Examples include a CEO resigning unexpectedly, a product recall, a legal lawsuit, or a sector being affected by new regulations. Because these risks do not affect the entire market, they can be reduced by spreading investments across many companies and industries.

For instance, if an investor puts all their money into one company and that company faces a scandal, the investment could lose most of its value. But if the investor holds shares in 50 different companies, the impact of a single company’s trouble on the overall portfolio is smaller.

This type of risk can be managed effectively through diversification. Owning a mix of stocks across sectors, along with bonds and other assets, helps reduce the chance that one company’s problems will significantly harm your total portfolio.

Understanding the distinction between unsystematic and systematic risk is key. While diversification is a powerful tool to reduce unsystematic risk, it cannot protect against the market-wide shocks caused by systematic risk.

How can you manage systematic risk if you can’t diversify it away?

Though systematic risk cannot be eliminated by diversification alone, investors can use several strategies to manage its impact:

1. Asset allocation

Allocating investments across various asset classes helps balance risk. For example, bonds and cash investments tend to be less volatile than stocks and may increase in value or hold steady when stocks fall. A portfolio with a mix of stocks, bonds, and other assets typically experiences smaller swings during market downturns compared to an all-stock portfolio.

2. Use of hedging strategies

More advanced investors sometimes use hedging tools like options contracts, futures, or inverse exchange-traded funds (ETFs). These instruments can provide gains or reduce losses when the market declines. However, hedging involves costs and risks and requires careful understanding before use.

3. Maintain liquidity through an emergency fund

Having cash savings equivalent to several months of living expenses can prevent the need to sell investments during market downturns. This allows investors to hold their positions and avoid locking in losses caused by systematic risk events.

4. Adopt a long-term investment view

Markets tend to recover over time from cyclical downturns driven by systematic risk. Sticking to a plan and not reacting impulsively to short-term declines can help investors benefit from market rebounds.

5. Adjust risk tolerance as needed

If you are close to needing your investment funds (for example, nearing retirement), consider reducing exposure to high-risk assets vulnerable to market-wide shocks by increasing allocations to more stable assets like bonds or cash equivalents.

By combining these strategies, investors can better withstand the unavoidable impact of systematic risk.

Why does systematic risk matter to individual investors?

Systematic risk matters because it explains why even a well-diversified portfolio can lose value during broad market downturns. Many investors expect diversification to protect them from all risk, but understanding the limits of diversification helps set realistic expectations.

For example, during major events like a financial crisis or geopolitical tension, most investments decline together. Knowing this can prevent panic selling and help investors stay committed to their long-term plans.

Systematic risk also influences how investors choose their asset allocation, balancing growth potential with the need for stability. Younger investors often tolerate higher levels of systematic risk by investing more in stocks, while retirees may prefer more conservative portfolios to protect against large market drops.

Being aware of systematic risk helps investors prepare mentally and financially for market volatility, making them less likely to make costly emotional decisions.

What related terms do people often confuse with systematic risk?

Several terms relate to or are confused with systematic risk:

• Market risk: Another name for systematic risk, referring to risks affecting the overall market.
• Unsystematic risk: Risk specific to individual companies or industries, which can be reduced by diversification.
• Idiosyncratic risk: Equivalent to unsystematic risk.
• Diversifiable risk: Another phrase for unsystematic risk, emphasizing that it can be minimized through diversification.
• Non-diversifiable risk: Another phrase for systematic risk, highlighting its inherent nature.

Knowing these terms helps investors understand which risks can be managed by diversification and which require other strategies.

What should you do next to manage risk in your investments?

To build a resilient investment portfolio considering systematic risk:

1. Assess your risk tolerance: Understand how much market volatility you can comfortably endure.
2. Diversify your portfolio: Spread investments across sectors, industries, and asset classes. For example, combine stocks with bonds, real estate, or commodities.
3. Review and rebalance regularly: Market changes can shift your portfolio’s risk profile. Adjust allocations periodically to maintain your desired balance.
4. Consider geographic diversification: Adding international investments can reduce dependence on a single country’s economic conditions.
5. Educate yourself on investment basics: Reading articles like How to Diversify Your Investment Portfolio and Why Diversification Reduces Investment Risk helps make informed choices.
6. Avoid trying to time the market: Instead, stick to a consistent investment plan focused on long-term goals.
7. Keep an emergency fund: This prevents forced selling during market downturns.

By following these steps, you can better handle the unavoidable influence of systematic risk and build a portfolio aligned with your financial goals.

Frequently asked questions

Can diversification completely eliminate investment risk?

No, diversification mainly reduces unsystematic risk related to individual investments. Systematic risk, caused by market-wide factors, affects nearly all assets and cannot be fully eliminated by diversification.

What is the difference between systematic and unsystematic risk?

Systematic risk affects the entire market due to broad economic or geopolitical events, while unsystematic risk is specific to a company or industry. Diversification can reduce unsystematic risk but not systematic risk.

How can I protect my portfolio from systematic risk?

You can manage systematic risk by diversifying across asset classes, maintaining an emergency fund, using hedging strategies if appropriate, and keeping a long-term investment perspective.

Is market risk the same as systematic risk?

Yes, market risk is another term for systematic risk. Both refer to risks affecting the whole market that cannot be diversified away.

Can bonds help reduce systematic risk?

Bonds often behave differently than stocks during market downturns, so including bonds in your portfolio can help moderate losses caused by systematic risk.