Unsystematic Risk

Definition

Unsystematic risk, also known as specific risk or idiosyncratic risk, refers to the inherent danger associated with investing in a particular asset or a group of assets. It is company or industry-specific risk that can be mitigated through diversification in an investment portfolio. Other factors like management performance, financial practices, and regulatory environment can also contribute to unsystematic risk.

Phonetic

The phonetics of the keyword “Unsystematic Risk” is: ʌnˌsɪstəˈmætɪk rɪsk

Key Takeaways

1. Individual Investment Risk: Unsystematic risk refers to the risk associated with a specific company or a particular sector. This means that unsystematic risks can be mitigated or eliminated through diversification of investments.
2. Influence of Microeconomic Factors: Unsystematic risk is influenced by microeconomic factors such as labour issues, mismanagement, product recalls and other company-specific events. Unlike systematic risk that is affected by macroeconomic factors, the unsystematic risk is inherent to a particular firm.
3. Controlled Through Diversification: The impact of unsystematic risk can be significantly reduced through portfolio diversification. By spreading investments across various assets, sectors, or companies, investors can limit their exposure to the risk associated with any one particular investment or sector.

Importance

Unsystematic risk, also known as specific risk or idiosyncratic risk, is critical in business/finance because it represents the inherent uncertainties associated with a specific company or industry. These may include factors such as management performance, consumer response to products, or labor strikes. As opposed to systematic risk that influences the overall market, unsystematic risk can be mitigated or eliminated through diversification, which involves spreading investments across various industries or companies. Therefore, it plays a vital role in portfolio management and investment strategies, highlighting the need for investors to diversify their portfolios to safeguard against potential losses associated with individual company or industry risks.

Explanation

Unsystematic risk, often also referenced as company-specific or idiosyncratic risk, is inherent to individual companies or specific sectors, and it can be maneuvered using various risk management techniques, such as diversification of portfolio. The purpose of understanding unsystematic risk is to analyze potential vulnerabilities within a specific company or industry. Investors and portfolio managers use it to decide where to allocate resources. By accurately assessing this type of risk, an investor can mitigate potential negative returns by avoiding investments that pose high unsystematic risk.The primary usage of unsystematic risk is in the construct of an effective portfolio management strategy. By considering the unsystematic elements, which include management competency, financial health, and position within the industry, investors ensure that not all their investments are vulnerable to the same types of risk. In other words, even if one sector or company faces a downturn, the entire portfolio doesn’t suffer because of the careful spread across assets that are not similarly affected. Thus, significance of unsystematic risk lies in its role in diversification; it drives the strategy for mix and balance in an investment portfolio for optimum benefit versus risk ratio.

Examples

1. Changes in Management: A company may encounter unsystematic risk if there are changes in the top management. For instance, if a highly capable CEO or a founder of a company departs abruptly, it may lead to uncertainty with regards to the future direction of the company. This can affect the stock price and overall company performance, and these risks are only pertinent to that particular company and not the entire market.2. Launch of a New Product: A business might introduce a new product or service with high expectations, but the product might fail to perform well in the market. For example, when Coca-Cola introduced “New Coke” in 1985, the product failed drastically due to negative customer responses. This represented a significant unsystematic risk as it affected only Coca-Cola and not other businesses in the market.3. Legal or Regulatory Issues: Companies can also face unsystematic risk due to legal troubles or regulation changes. Let’s take the example of Volkswagen – In 2015, the emission scandal, commonly known as ‘Dieselgate’ , led to billions in fines, lawsuits, and vehicle recalls for the company. This issue presented an unsystematic risk as it was specific to Volkswagen, and did not affect the entire automobile sector.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Company-specific Risk
• Diversifiable Risk
• Non-market Risk
• Idiosyncratic Risk
• Business Risk

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Wall Street Mojo
• Finance Train