📚 PASS Research Analyst Certification Examination Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 12.3 — Risks in Investments

Imagine you are finalizing a sector report on the Indian pharmaceutical industry for a prominent domestic brokerage. Your client, a portfolio manager, asks why the stock of a mid-sized drug manufacturer plummeted 10% after a USFDA inspection, even though the Nifty Pharma index remained relatively stable. Your task here is to identify that the decline was driven by unsystematic risk—firm-specific operational failure—which could have been dampened had the portfolio been more diversified across different therapeutic segments or geographies.

As an analyst, distinguishing between these two components is not just academic; it is the mathematical foundation of modern portfolio construction.

Systematic risk, or market risk, represents the ’non-diversifiable’ component that stems from macroeconomic factors like RBI interest rate hikes, geopolitical tensions, or systemic shocks like a global pandemic. Mathematically, this is the portion of an asset’s variance that correlates perfectly with the broader market. Because it affects all participants, no amount of security selection can neutralize it. In your valuation models, this is explicitly accounted for in the ‘Beta’ of the CAPM formula, which measures the asset’s sensitivity to market movements.1

Conversely, unsystematic risk—also known as idiosyncratic or diversifiable risk—is unique to the entity or its specific industry. Examples include labor strikes, management fraud, or poor inventory turnover. By adding more non-correlated assets to a portfolio, the idiosyncratic risks of individual securities begin to offset one another. As the number of stocks in a portfolio increases, the unsystematic variance trends toward zero, leaving only the systematic risk remaining as the primary driver of returns.

To calculate the degree of diversification, analysts often utilize a correlation matrix across the intended portfolio. If you are constructing a basket of stocks to mitigate volatility, you must look for assets with low or negative correlation coefficients. A portfolio of ten stocks in the same sector often fails to mitigate unsystematic risk effectively because those companies likely share common regulatory and supply-chain vulnerabilities.

True risk management, therefore, lies in constructing a portfolio where the sum of diversifiable risks is minimized, ensuring the client is compensated solely for the non-diversifiable risk they are forced to bear.

Nuance

⚠️ Nuance
A common pitfall is the belief that ‘diversification’ simply means owning more stocks. Candidates often assume that adding more securities automatically reduces risk, ignoring the correlation coefficient. If you hold thirty stocks that are all highly correlated with crude oil prices, you have not diversified; you have merely concentrated your exposure to a single systematic factor.

Check Your Understanding

Practice Question 1

An analyst observes that a portfolio of 25 stocks in the Indian IT sector still exhibits high volatility during local policy changes. Which statement best describes the risk profile of this portfolio?

Practice Question 2

Which component of total risk is theoretically reduced to zero as an investor increases the number of assets in a perfectly diversified portfolio?

This is a companion read for Section 12.3 — Risks in Investments from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. Beta (β) represents the slope of the security’s returns relative to the market return; a Beta of 1.0 implies the asset moves in lockstep with the Nifty 50. ↩︎