The risk-return trade-off explains that the higher the risk factor, the greater the profit. However, if you want to increase your rate of return, you need to take some risks. You can mitigate risk through portfolio diversification and asset allocation. There are two types of risk that affect most, if not all, asset classes, namely systematic and unsystematic risk. Systematic risk affects the financial market as a whole, while unsystematic risk only occurs in certain companies or investments.
Since both types of risks are unavoidable in every financial decision, it is important to understand the differences between them and learn how to mitigate them. This post further explores unsystematic risk from a stock market perspective. Examples of unsystematic risk include management inefficiency, flawed business models, liquidity problems, regulatory changes, or worker strikes. Systematic risk cannot be diversified, while unsystematic risk can generally be mitigated through diversification. Unsystematic risk, in the case of stock investments, can be measured by unsystematic variance. It is calculated by subtracting the systematic variance from the total variance.
Understanding Unsystematic Risk
Unsystematic risk is a risk that is unique to a particular company or industry. This is 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 inherent in the market.
Unsystematic risk can be described as the uncertainty inherent in the investments of a company or industry. Examples of unsystematic risk include new competitors in the market that have the potential to take significant market share from the investing company, regulatory changes, management changes, or product recalls. For example, investors in healthcare stocks may be aware that a major change in health policy is coming, but may not fully know the details of the new law and how companies and consumers will respond to it.
Other examples of unsystematic risks are strikes, the consequences of legal proceedings, or natural disasters. This risk is also known as diversifiable risk because this risk can be eliminated by diversifying the portfolio sufficiently.
Types of Unsystematic Risk
There are five types of unsystematic risks, namely business, financial, operational, strategic and legal/regulatory risks.
1. Business risk
Internal and external problems can pose business risks. Internal risks are related to operational efficiency. For example, management’s failure to take out a patent to protect a new product would be an internal risk, as this could result in a loss of competitive advantage. The Food and Drug Administration (FDA) banning certain drugs that companies sell is an example of an external business risk. Recently, TikTok, the Chinese-owned internet dynamo, has been banned on most US state and federal government devices.
2. Financial risks
Financial risk is related to the capital structure of a company. A company needs to have optimal levels of debt and equity to continue to grow and meet its financial obligations. A weak capital structure can lead to inconsistent earnings and cash flow which can prevent a company from trading. In an environment where the Fed raises interest rates, some companies’ balance sheets may be stuck with lower-yielding investments.
3. Operational risk
Security breaches can reveal confidential information about customers or other types of critical data holdings to criminals. Operational risks relate to operations and potential system or policy failures. This is a risk to daily operations and can be disrupted by internal failure procedures, both related to systems and employees. For example, a refinery may experience a leak in one of its holding tanks, halting production until the damage can be repaired.
4. Strategy risk
Strategic risk can occur if a business gets caught up in selling goods or services in a current industry without a strong plan for developing the company’s offering. A company can also face this risk through the wrong partnerships with other companies or competitors that harm their future growth prospects.
5. Legal and regulatory risks
Legal and regulatory risk is the risk that changes to laws or regulations will harm a business. These changes may increase operational costs or create legal obstacles. More drastic legal or regulatory changes could even halt business operations altogether, such as a potential ban on TikTok in the US by the US government.
Difference between Unsystematic Risk & Systematic Risk
The total risk in investing is unsystematic risk plus systematic risk. Unsystematic risk is the risk that is specific to a company or industry, while systematic risk is the risk related to the broader market, which is why this risk is also referred to as market risk. Systematic risk is associated with broad market factors and is the risk of an investment portfolio that is not based on individual investments. Systematic risk is an inherent risk that exists in the stock market. This risk is also called “non-diversifiable risk” or “market risk” because it impacts entire asset classes.
Non-diversification means that an organization cannot control, minimize, or avoid systematic risks. These risks are usually caused by various external factors such as the current geopolitical situation, monetary policy, and natural disasters. Unsystematic risk, also known as “nonsystematic risk,” “specific risk,” “diversifiable risk,” or “residual risk,” is unique to a particular company or industry. This risk arises due to various internal factors or external factors that only affect certain organizations but do not affect the market as a whole.
Types of systematic risk can include changes in interest rates, recession, or inflation. Systematic risk is often calculated by beta, which measures the volatility of a stock or portfolio relative to the overall market. Meanwhile, company risk is a little more difficult to measure or calculate. Systematic and unsystematic risks can be mitigated by risk management. Systematic risk can be reduced by asset allocation, while unsystematic risk can be limited by diversification.
Systematic risks have the potential to impact entire industries and the economy as a whole, while unsystematic risks generally impact organizations. Systematic risk cannot be diversified, while unsystematic risk can be diversified. Systematic risk cannot be avoided and controlled, while unsystematic risk can be avoided and controlled. Systematic risk is caused by external factors that occur at the macroeconomic level, so it cannot be avoided and controlled.
Example of Unsystematic Risk
By owning a variety of shares of companies in different industries, as well as by owning other types of securities in various asset classes, such as Treasuries and municipal securities, investors will be less affected by a single event. For example, an investor, who owns nothing but airline stocks, will be exposed to a high level of unsystematic risk. They would be vulnerable if airline industry employees went on strike, for example. This event could drop airline share prices, even if only temporarily.
Unsystematic risk, in this case, not only impacts certain airlines but also several industries, such as large food companies, which are business partners of many airlines. In this case, investors can diversify away from public equities by adding US Treasury bonds as additional protection from stock price fluctuations. Even a well-diversified asset portfolio cannot be free from all risks.
Some examples of unsystematic risks include worker unrest in factories, regulatory changes, and raw material shortages. In contrast to systematic risk, unsystematic risk can be controlled, minimized and even avoided by an organization. *
Conclusion
Unsystematic risk, or company-specific risk, is the risk associated with a particular investment. Unsystematic risk can be mitigated through diversification, so it is also called diversifiable risk. After diversifying, investors still face broad market systematic risks. Total risk is unsystematic risk plus systematic risk. Systematic risk is associated with broad market factors and is the risk of an investment portfolio that is not based on individual investments.
Unsystematic risk is diversifiable, meaning that if you buy shares of different companies in different industries, you can reduce this risk. Unsystematic risk is often associated with a particular company or industry and can be avoided by building a well-diversified portfolio.
