Unsystematic risk, also known as diversifiable risk or non-systematic risk, is the danger that relates to a particular security or a portfolio of securities.
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 Features:
- Unsystematic risk, or company-specific risk, is a risk associated with a particular investment.
- It 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.
Examples of Unsystematic Risk
Examples of unsystematic risk are as follows:
-
A change in regulations that impacts one industry
-
The entry of a new competitor into a market
-
A company is forced to recall one of its products
-
A company is found to have prepared fraudulent financial statements
-
A union targets a company for an employee walkout
-
A foreign government expropriates the assets of a specific company
Types of Unsystematic Risk
Business Risk
Business risk is the uncertainty that arises due to the nature of the business activity that the company you are investing in is engaged in.
For example, very speculative businesses or those that are in a new industry face a higher degree of uncertainty than businesses in more stable industries.
Note: A business that is involved in developing new medicines, for example, faces higher business risk compared to a company that provides utility services.
In this case, the company in a new or volatile industry has less certainty for success and guaranteed revenue.
Financial Risk
Firms must finance their assets in one way or another. Owners of companies may contribute all of the capital needed to fund the business, they can issue securities like stocks and bonds, or they can borrow money from a bank or other lender.
Note: The way that a business chooses to fund its assets is called its capital structure. A firm’s choice of capital structure is a source of risk as well.
Operational Risk
Operational risks can result from unforeseen or negligent events, such as a breakdown in the supply chain or a critical error 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.
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.
Calculation of Unsystematic Risk
That is calculated by subtracting systematic variance from the total risk.
Unsystematic risk = Total risk – Systematic Risk
Conclusion
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.
