What is Unsystematic Risk?

Unsystematic Risk

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Unsystematic Risk

Unsystematic risk, also known as “specific risk,” “diversifiable risk,” or “idiosyncratic risk,” refers to the risk associated with a particular investment, such as an individual stock or bond, which is independent of the overall market risk. This type of risk can arise from factors that are specific to a particular company or industry, such as management performance, labor strikes, or regulatory changes. Because unsystematic risk is unique to a specific company or industry, it can be reduced or eliminated through diversification—by holding a wide variety of investments in a portfolio.

Here are some examples of unsystematic risk:

  • Management Changes: A sudden resignation of a key executive might affect the stock price of a company.
  • Product Recalls: If a car manufacturer has to recall one of its models due to safety issues, the company’s stock price may decline as a result.
  • Regulatory Risk: A pharmaceutical company may face new regulations that restrict the sale of one of its key drugs, negatively affecting its stock price.
  • Supply Chain Issues: A technology company might face supply chain disruptions affecting the availability of key components, leading to decreased revenue and affecting its stock price.
  • Labor Strikes: If a company’s workforce goes on strike, production could halt, leading to financial losses and a negative impact on its stock.
  • Legal Issues: A lawsuit against a company could result in financial penalties and tarnish the company’s reputation, potentially affecting its stock price.

By holding a diversified portfolio, an investor can mitigate the impact of unsystematic risks. This is because the positive performance of some investments can offset the negative performance of others, reducing the volatility of the portfolio as a whole.

It’s worth noting that unsystematic risk is different from systematic risk, which is the risk inherent to the entire market or a market segment and cannot be diversified away. Systematic risks include factors like interest rate changes, inflation, or political instability that affect the broad market.

Investors often use a combination of asset allocation, diversification, and risk assessment to manage both systematic and unsystematic risks in their portfolios.

Example of Unsystematic Risk

Let’s consider a hypothetical example involving two investors, Alice and Bob, who are both interested in the technology sector.

Alice’s Portfolio:

Alice decides to invest her entire savings of $10,000 into a single tech company, “TechCorp.”

Unsystematic Risk:

  • Six months later, TechCorp faces a significant cybersecurity breach, and its stock plummets 40%.
  • Alice’s portfolio, being entirely invested in TechCorp, also loses 40% of its value, reducing her investment to $6,000.

Bob’s Portfolio:

Bob also has $10,000 to invest but chooses a diversified approach. He spreads his $10,000 across 10 different technology companies, investing $1,000 into each.

Unsystematic Risk:

  • Just like TechCorp in Alice’s portfolio, one of the companies in Bob’s portfolio suffers a cybersecurity breach and its stock value decreases by 40%.
  • However, the other nine companies in Bob’s portfolio perform well, each gaining 5% in value over the same period.

Here’s how Bob’s portfolio would fare:

  • The stock that suffered from the breach now has a value of $600 (a loss of $400).
  • Each of the other nine stocks is now worth $1,050 (a gain of $50 per stock).
  • Bob’s total portfolio value is $600 (from the stock that decreased) + $9,450 (from the 9 stocks that increased) = $10,050.

In this example, Alice’s non-diversified portfolio was more vulnerable to unsystematic risk, resulting in a significant loss when TechCorp faced issues. On the other hand, Bob diversified his portfolio, mitigating the impact of unsystematic risk. Even though one of the companies in his portfolio suffered, the positive performance of the other companies helped to offset the loss.

This example illustrates why diversification is often recommended as a risk management strategy: it can significantly reduce the impact of unsystematic risks associated with individual companies or sectors.

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