What Is Unsystematic Risk?
Unsystematic risk is the risk that is unique to a specific company or industry. It's also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk. In the context of an investment portfolio, unsystematic risk can be reduced through diversification—while systematic risk is the risk that's inherent in the market.
Key Takeaways
- Unsystematic risk, or company-specific risk, is a risk associated with a particular investment.
- Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk.
- Once diversified, investors are still subject to market-wide systematic risk.
- Total risk is unsystematic risk plus systematic risk.
- Systematic risk is attributed to broad market factors and is the investment portfolio risk that is not based on individual investments.
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Understanding Unsystematic Risk
Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. Examples of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in,a regulatory change(which could drive down company sales),a shift in management, or a product recall.
While investors may be able to anticipate some sources of unsystematic risk, it is nearly impossible to be aware of all risks. For instance, an investor in healthcare stocks may be aware that a major shift in health policy is on the horizon, but may not fully know the particulars of the new laws and how companies and consumers will respond.
Other examples of unsystematic risks may include strikes, outcomes of legal proceedings, or natural disasters. This risk is also known as a diversifiable risk since it can be eliminated by sufficiently diversifying a portfolio. There isn't a formula for calculatingunsystematic risk; instead, it must be extrapolated by subtracting the systematic risk from the total risk.
Types of Unsystematic Risk
Business Risk
Both internal and external issues may cause business risk. Internal risks are tied to operational efficiencies. For example, management failing to take out a patent to protect a new product would be an internal risk, as it may result in the loss of competitive advantage.
TheFood and Drug Administration(FDA) banning a specific drug that a company sells is an example of external business risk. Most recently, TikTok, the Chinese-owned, internet dynamo, has been banned from most US state and federal government devices. Meanwhile a broader consideration to totally ban TikTok in the US has evolved as a new unsystematic risk.
Financial Risk
Financial risk relates to the capital structure of a company. A company needs to have an optimal level of debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow that could prevent a company from trading. In the current environment of the Fed raising interest rates, some companies balance sheets may be stuck with lower-yielding investments. With interest rates moving higher, they would presumably seek to replace existing low-yield debt with newer, higher-yielding debt investments.
Operational Risk
Operational riskscan result from unforeseen or negligentevents, such as a breakdown in the supply chain or a criticalerror being overlooked in the manufacturing process. A security breach could expose confidential information about customers or other types of key proprietary data to criminals.
Operational risk is tied to operations and the potential for failed systems or policies. These are the risks for day-to-day operations and can result from breakdowns in internal procedures, whether tied to systems or employees. For example, a refinery may experience a leak from one of its holding tanks, shutting down production until the damage can be repaired. Meanwhile, the refinery is offline and not producing the refined products that customers are demanding, leaving the refinery without any income for a period of time.
Strategic Risk
A strategic risk may occur if a business gets stuck selling goods or services in a dying industry without a solid plan to evolve the company's offerings. A company may also encounter this risk by entering into a flawed partnership with another firm or competitor that hurts their future prospects for growth.In the current environment, there is a rush to develop electronic cars, for example, opening up a whole new field of competition within the auto industry. Those late to the game are facing significant strategic risk.
Legal and Regulatory Risk
Legal and regulatory risk is the risk that a change in laws or regulations will hurt a business. These changes can increase operational costs or introduce legal hurdles. More drastic legal or regulation changes can even stop a business from operating altogether, such as with the potential ban on TikTok in the US by the US government. Other types of legal risk can include errors in agreements or violations of laws.
Unsystematic Risk vs. Systematic Risk
The total risk for investments is unsystematic risk plus systematic risk. Unsystematic risk is a risk specific to a company or industry, while systematic risk is the risk tied to the broader market—which is why it's also referred to as market risk. Systematic risk is attributed to broad market factors and is the investment portfolio risk that is not based on individual investments.
Types of systematic risks can include interest rate changes, recessions, or inflation. Systematic risk is often calculated with beta, which measures the volatility of a stock or portfolio relative to the entire market. Meanwhile, company risk is a bit more difficult to measure or calculate.
Systematic and unsystematic risks can be mitigated, in part, with risk management. Systematic risk can be reduced with asset allocation, while unsystematic risk can be limited with diversification.
Example of Unsystematic Risk
By owning a variety of company stocks across different industries, as well as by owning other types of securitiesin a variety of asset classes, such as Treasuries and municipal securities, investors will be less affected by single events.
For example, an investor, who owned nothing but airline stocks, would face a high level of unsystematic risk (also known as idiosyncratic risk). They would be vulnerable if airline industry employees went on strike, for example. This event could sink airline stock prices, even temporarily. Simply the anticipation of this news could hamper their portfolio.
By adding uncorrelated holdings to their portfolio, such as stocks outside of the transportation industry, this investor would spread out air-travel-specific concerns. Unsystematic risk, in this case, affects not only specific airlines but also several of the industries, such as large food companies, with which many airlines do business. In this regard, the investor could diversify away from public equities altogether by adding U.S. Treasury bonds as additional protection from fluctuations in stock prices.
Even a portfolio of well-diversified assets cannot escape all risk, however. The portfolio will still be exposed to systematic risk, which refers to the uncertainty that faces the market as a wholeand includes shifts in interest rates, recessions, financial crises, wars, and natural disasters.
What Are Examples of Unsystematic Risk?
Key examples of unsystematic risk include management inefficiency, flawed business models, liquidity issues, regulatory changes, or worker strikes.
What Is the Difference Between Systematic and Unsystematic Risk?
Systematic risk is not diversifiable (i.e. cannot be avoided), while unsystematic risk can generally be mitigated through diversification. Systematic risk affects the market as a whole and can include purchasing power or interest rate risk.
What Are Types of Unsystematic Risk?
There are five types of unsystematic risk—business, financial, operational, strategic, and legal/regulatory risk.
How Is Unsystematic Risk Measured?
Unsystematic risk—when it comes to investing in stocks—can be measured by the unsystematic variance. That is calculated by subtracting systematic variance from the total variance.
The Bottom Line
Unsystematic risk is diversifiable, meaning that (in investing) if you buy shares of different companies across various industries you can reduce this risk. Unsystematic risks are often tied to a specific company or industry and can be avoided by building a well-diversified portfolio.
Systematic risk is a non-diversifiable risk or a measure of overall market risk. These factors are beyond the control of the business or investor, such as economic, political, or social factors. Meanwhile, microeconomic factors that affect companies are unsystematic risks, such as an unforeseen rise in oil prices.
