Editing Systematic risk (section)

==In finance==

Systematic risk plays an important role in [[Asset allocation|portfolio allocation]].<ref>{{cite book |last1=Maginn |first1=J. |last2=Tuttle |first2=D. |last3=McLeavey |first3=D. |last4=Pinto |first4=J. |year=2007 |title=Managing Investment Portfolios: A Dynamic Process |url=https://archive.org/details/managinginvestme00ljoh |url-access=registration |location=Hoboken, New Jersey |publisher=John Wiley & Sons |pages=[https://archive.org/details/managinginvestme00ljoh/page/n241 231]–245 |isbn=9780470171608 }}</ref> Risk which cannot be eliminated through diversification commands returns in excess of the [[Risk-free interest rate|risk-free rate]] (while idiosyncratic risk does not command such returns since it can be diversified). Over the long run, a well-diversified portfolio provides returns which correspond with its exposure to systematic risk; investors face a trade-off between expected returns and systematic risk. Therefore, an investor's desired returns correspond with their desired exposure to systematic risk and corresponding asset selection. Investors can only reduce a portfolio's exposure to systematic risk by sacrificing expected returns.

An important concept for evaluating an asset's exposure to systematic risk is [[Beta (finance)|beta]]. Since beta indicates the degree to which an asset's return is correlated with broader market outcomes, it is simply an indicator of an asset's vulnerability to systematic risk. Hence, the [[capital asset pricing model|capital asset pricing model (CAPM)]] directly ties an asset's equilibrium price to its exposure to systematic risk.

===A simple example===

Consider an investor who purchases stock in many firms from most global industries. This investor is vulnerable to systematic risk but has diversified away the effects of idiosyncratic risks on his portfolio value; further reduction in risk would require him to acquire risk-free assets with lower returns (such as [[United States Treasury security|U.S. Treasury securities]]). On the other hand, an investor who invests all of his money in one industry whose returns are typically uncorrelated with broad market outcomes ([[beta (finance)|beta]] close to zero) has limited his exposure to systematic risk but, due to lack of diversification, is highly vulnerable to idiosyncratic risk.