MPT states that the risk for individual stock returns has two components:

Systematic Risk – These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.

Unsystematic Risk – Also known as «specific risk», this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see Figure 1). It represents the component of a stock’s return that is not correlated with general market moves.

For a well-diversified portfolio, the risk of each stock contributes little to portfolio risk. Instead, it is the difference – or covariance – between individual stocks’ levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.