Unsystematic Risk: Definition & Examples

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. Consider an investor who purchases stock in many firms from most global industries. When you invest in a wide array of assets from different sectors and industries, you spread the risk. This means the negative performance of one asset could be offset by the positive performance of another.

The Great Recession affected asset classes in different ways, as riskier securities (e.g., those that were more leveraged) were sold off in large quantities, while simpler assets, such as U.S. Company and industry-specific risks are mitigated by “spreading” the risk across a wide range of investments in different securities, asset classes or geographies. By maintaining a diversified portfolio with holdings across different, uncorrelated securities or asset classes, an investor can reduce the impact of idiosyncratic risk on the returns of the overall portfolio. Key examples of unsystematic risk include management inefficiency, flawed business models, liquidity issues, regulatory changes, or worker strikes. By adding uncorrelated holdings to their portfolio, such as stocks outside of the transportation industry, this investor would spread out air-travel-specific concerns.

Company-Specific Risks

Systematic risk, also known as un-diversifiable risk, is the inherent risk of an investment that cannot be diversified away. This type of risk is usually caused by factors beyond the investor’s control, such as macroeconomic factors or political conditions. Systematic risk affects all investments in a given market to some degree. Following these guidelines allows investors to effectively distribute unsystematic risks across a wide range of underlying assets. By optimizing asset allocation, investors manage systematic risk through position sizing while minimizing unsystematic risk through diversification.

While individual companies can take steps to minimize unsystematic risks through strong internal controls, these risks cannot be fully avoided. While diversification is effective for controlling unsystematic risk, it cannot safeguard a portfolio against systematic risk. Still, diversification remains a key risk management tool for investors. For example, an investor can manage systematic risk by investing in a combination of stocks, bonds, and commodity assets. To address unsystematic risk, the investor can ensure their stock investments are spread across different sectors, such as technology, healthcare, and consumer goods. The following are some examples of unsystematic risks that companies might face.

Beta measures how volatile that investment is compared to the overall market. A beta of greater than one means the investment has more systematic risk than the market, while less than one means less systematic risk than the market. A beta equal to one means the investment carries the same systematic risk as the market.

1. It is the uncertainty that comes with operating in a particular sector, caused by factors like management decisions, financial practices, or events related to the firm.
2. Most investment strategies balance both risk types using asset allocation – distributing a portfolio between stocks, bonds, real estate, cash, and other assets based on goals, time horizon, and risk tolerance.
3. This research confirmed earlier advice from Benjamin Graham in his 1949 book, The Intelligent Investor.
4. The whole of the technology sector may end up performing very well, while companies with poor entrepreneurial foresight suffer.
5. But systematic risk cannot be diversified away, since entire markets are moving in sync.
6. Making sure that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities.

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Often used interchangeably with the term “idiosyncratic risk”, unsystematic risk can be mitigated via portfolio diversification. Tactical asset allocation then involves periodically rebalancing between asset classes to maintain the target allocation. This forces investors to buy low and sell high – adding equities after market declines and trimming them after rallies to capture value.

1. For example, if a portfolio is balanced and diversified, and a stock declined because of the company’s bad earnings, the rest of the assets should not be affected by the issues of one specific company.
2. RJO Futures provides investors with access to a world-class team of investment professionals who can provide critically important context and guidance with regard to systematic and unsystematic risk.
3. Vaia is a globally recognized educational technology company, offering a holistic learning platform designed for students of all ages and educational levels.
4. However, systematic risk incorporates interest rate changes, inflation, recessions, and wars, among other major changes.
5. While investors may be able to anticipate some sources of unsystematic risk, it is nearly impossible to be aware of all risks.
6. By maintaining a diversified portfolio with holdings across different, uncorrelated securities or asset classes, an investor can reduce the impact of idiosyncratic risk on the returns of the overall portfolio.

Phrased another way, 61% of stock risk can be eliminated by owning 200+ stocks (or a single, broad-based U.S. stock index fund); 56% risk reduction with just 20 stocks from several sectors. The total risk for a well-diversified stock portfolio is basically equivalent to systematic risk. While an investor expects to be rewarded for bearing risk, one is not rewarded for taking on unnecessary risk, such as unsystematic risk.

Key Takeaways

Investing in a security typically involves exposure to both systematic and unsystematic risk. Some common types of unsystematic risk include business risk, financial risk, operational risk, strategic risk, and legal or regulatory risk. Many of these are systematic risks, meaning that they are widespread throughout the market.

Another is the probability that the actual unsystematic risk is also known as return of an investment will differ from its expected return. A third definition is the variability of returns from an investment compared to the investment’s average return (this means returns go up and down more than expected). • Arises from factors like management issues, product recalls, or regulatory changes. Other risks are unsystematic, meaning that they affect Tesla more than competing manufacturers. Tesla’s operations are centered around several gigantic manufacturing plants that benefit from favorable subventions by local governments.

Imagine a leading smartphone manufacturer facing unsystematic risk due to a major product flaw. The resulting recall impacts its brand image and incurs costs that competitors are not subject to. This risk is specific to the company and not reflective of the whole technology sector. As the number of securities in a portfolio increases, unsystematic risk gets diversified away, eventually becoming negligible. It has been suggested that a portfolio of 12 to 18 stocks is sufficient to achieve maximum diversification possible, depending on correlation of returns between the securities.

Therefore, risk-averse investors should hold well-diversified portfolios. Today, we’ll dive into the fascinating world of systematic and unsystematic risk, which affect individual assets and portfolios. Since there is no advantage to investing in companies with high unsystematic risk, unsystematic risk does not factor into the calculations of a company’s risk premium. Reducing systematic risk can lower portfolio risk; using asset classes whose returns are not highly correlated (e.g., quality bonds, stocks, fixed-rate annuities, etc.). It is possible to have higher risk-adjusted returns without having to accept additional risk, a process called portfolio optimization.

In general, unsystematic risk can be managed through diversification, while systematic risk cannot be avoided. This is why diversification is often recommended as a risk management strategy for investors. Systematic risk refers to market-wide uncertainties that affect all firms, such as recessions, wars, interest rate changes, and inflation. Unsystematic risk refers to firm-specific uncertainties like lawsuits, strikes, defective products, etc.

While diversification cannot completely eliminate unsystematic risk, it can be reduced. The key difference is that investors can minimize unsystematic risk via diversification across assets, sectors, and geographies. But systematic risk cannot be diversified away, since entire markets are moving in sync. Diversification involves allocating investments across different assets, sectors, markets, and geographic regions to mitigate risks. By limiting exposure to any single investment, diversification aims to reduce unsystematic risk.