What is the relationship between systematic risk and portfolio diversification?

Systematic risk, often referred to as market risk, is the portion of risk that affects all securities within a market. It is tied to external factors such as economic changes, political events, or natural disasters and cannot be eliminated through diversification. This type of risk affects the entire market or a broad segment of the market, meaning that even a well-diversified portfolio—which might effectively reduce unsystematic risk (the risk unique to individual assets)—is still subject to systematic risk.

Therefore, while diversification can mitigate some risks (specifically unsystematic risk) by spreading investments across various assets, it does not impact the inherent risks that are correlated with the market as a whole. Investors must consider methods such as hedging or asset allocation to manage systematic risk because diversification alone will not protect against these broader market movements.

This understanding highlights why systematic risk remains a critical factor in investment strategy and financial planning, emphasizing the importance of recognizing the limitations of diversification in reducing overall portfolio risk.