Expert Level

Learn advanced topics about trading strategies, risk management and more.

Lesson 9: Unsystematic Risk

What is Unsystematic Risk?

Unsystematic
risk is special to a specific company or industry. Often known as
“non-systematic risk,” “specific risk,” “diversifiable risk.” or “residual risk,”
in the sense of an investment portfolio, non-systematic risk may be minimized
by diversification.

This can
be contrasted with the systemic risk inherent in the market.

Understanding Unsystematic Risk

Unsystematic
risk may be defined as an uncertainty inherent in a business or an industry
investment. Unsystematic risk categories include a new competitor on the market
with the ability to take significant market share from the company invested in,
a regulatory change (which could drive down company sales), a switch in
leadership and/or product recall.

Although
investors may be able to predict certain sources of non-systematic threat, it
is impossible to know when or how they will occur. For example, an investor in
healthcare stocks may be aware that a major shift in health policy is on the
horizon, but he/she cannot know in advance the details of the new legislation
and how companies and consumers will respond. The incremental implementation
and eventual repeal of the Affordable Care Act, first enacted in 2010, has made
it very difficult for some investors in healthcare stocks to predict and
position positive bets on the future of the market and/or individual
businesses.

Examples
include such events as accidents, the results of legal proceedings and natural disasters.
This risk is also known as a diversifiable risk, as it can be minimized by
adequately diversifying the portfolio. There is no equation for estimating
unsystematic risk; rather, it must be extrapolated by subtracting the systemic
risk from the total risk.

Company-Specific Risk

Two
factors give rise to company-specific risk:

  • Business
    Risk: both internal and external issues can give rise to business risk.
    Internal hazard is related to the operational efficiency of the company. For
    example, a management failure to secure a patent to protect a new product would
    constitute an internal threat, as it could result in a loss of competitive
    advantage. The Food and Drug Administration (FDA) forbidding a specific drug
    that a company sells is an example of internal business risk.
  • Financial
    risk: financial risk applies to the company’s capital structure. A company
    needs to have an optimal level of debt and equity to continue to grow and
    fulfill its financial obligations. A poor capital structure could lead to volatile
    earnings and cash flow that could stop a company from trading. (See also the
    Q&A: What are the major categories of financial risk for a company?)

Operational
risks that arise from unexpected and/or incompetent incidents, such as a
failure in the supply chain or a critical error being overlooked in the
manufacturing process. Security breaches can expose sensitive customer
information or other types of key proprietary data to criminals.

A strategic
risk can occur if a business is stuck selling goods or services in a dying
industry without a clear plan to develop the company’s offerings. A business
may also face this threat by entering into an unethical relationship with
another firm or competitor that threatens its future growth prospects.

Legal and
regulatory risks can subject a company to a multitude of liabilities and
potential lawsuits from consumers, suppliers and competing firms. It may also
be difficult to guard against enforcement actions by government agencies or
changes in legislation.

Example of Unsystematic Risk

Through
holding a variety of corporate stocks through sectors, as well as by owning
certain forms of securities in a variety of asset classes, such as treasuries
and municipal securities, shareholders will be less impacted through single
events. For example, an investor who owned nothing but airline stocks will face
a high level of non-systematic threat. It could become vulnerable if workers of
the airline industry, for instance, were to go on strike. Perhaps briefly, this
occurrence could bring down airline stock prices. Clearly expecting this news
could be devastating for her portfolio.

By adding
non-correlated investments to its portfolio, such as stocks outside the
transport sector, this shareholder will spread air travel-specific concerns.
Unsystematic risks in this case concern not only individual airlines, but also
a variety of sectors, such as large food firms, with which many airlines work.
In this regard, it could completely diversify away from public equities by
incorporating US Treasury Bonds as additional protection against volatility in
stock prices.

Nevertheless, even a
portfolio of well-diversified capital cannot avoid all risks. The fund will
still be exposed to systemic risk, which applies to the volatility that the
economy faces and involves fluctuations in interest rates, presidential
elections, financial crises, conflicts and natural disasters.