Definition
Unsystematic risk, also known as specific risk or idiosyncratic risk, refers to the inherent risk in investing in a particular asset—such as a company’s stock—that can be mitigated through diversification. It’s linked to issues specific to a particular company or industry, like management performance, product recalls, and labor disputes. Unlike systematic risk, which affects a broad range of assets, unsystematic risk can be reduced by holding a diversified portfolio of assets.
Key Takeaways
- Unsystematic Risk refers to the inherent dangers associated with investing in a specific company or industry. It is also known as company-specific or idiosyncratic risk.
- Unlike systematic risk that affects the entire market, unsystematic risk can be significantly reduced or even eliminated through diversification, that is, by investing in a diverse portfolio of stocks, bonds, and other securities.
- This type of risk is often linked to factors such as business strategy, management, financial practices, or changes in a particular industry or economic sector, and can therefore have significant impact on individual stocks and not the stock market as a whole.
Importance
Unsystematic risk, also referred to as idiosyncratic or specific risk, is important because it represents the component of investment risk that is directly related to the individual characteristics of a company or a specific group of companies.
This type of risk can be effectively reduced or eliminated through the process of diversification and thus, it plays a crucial role in portfolio management strategies.
Investors, fund managers, and financial analysts pay special attention to unsystematic risk to identify investment opportunities that can potentially enhance returns while reducing risk through effective asset allocation.
Understanding unsystematic risk can also help in making informed decisions about individual stocks based on the company’s specific risk factors such as efficiency of its management, production processes, and industry trends.
Explanation
Unsystematic risk, also referred to as specific risk, idiosyncratic risk, or diversifiable risk, pertains to the inherent dangers associated with investing in a specific company or industry. It involves the risk factors that are directly related to the organization’s operations and business environment.
In essence, it pertains to the uncertainties and potential financial losses that arise from company-specific or industry-specific events. Unsystematic risk can be linked to factors like labour strikes, mismanagement, product recalls, or any unforeseen disaster that hits a company.
The main purpose of identifying and quantifying unsystematic risk is to help investors make informed decisions about their investment portfolio. It aids in their understanding of how much potential risk they are assuming when investing in a particular company or industry, and thus, they can better manage their investments to mitigate potential losses.
Since unsystematic risks are not correlated with market risk and are unique to a specific firm, these risks can be substantially minimized by diversifying the investment across different companies or sectors within various industries, thus acting as a crucial factor that drives asset allocation strategies for investors.
Examples of Unsystematic Risk
Company Leadership Changes: If a CEO or other high-level executive at a firm suddenly resigns or is fired, this can cause instability and uncertainty within the company. This could potentially have a negative impact on the company’s stock price, revenues, or overall business operations. This is an unsystematic risk as it only affects that particular company, not the entire market or industry.
Product Failures: If a company launches a new product that does not meet market expectations or results in a public backlash due to a fault or defect (like Samsung’s Galaxy Note 7 battery explosion issues), this can have a significant impact on the company’s financial performance. This is an example of an unsystematic risk since it only affects the specific company that produced and marketed the faulty product.
Legal Troubles: If a company faces lawsuits or regulatory fines, it can significantly affect its financial standing. A perfect example is the pharma giant Johnson & Johnson, which faced several lawsuits over its talc-based baby powder. Such instances are considered unsystematic risks because they are company-specific and do not reflect broader market conditions.
FAQs about Unsystematic Risk
1. What is Unsystematic Risk?
Unsystematic risk, also known as specific risk, diversifiable risk, idiosyncratic risk, or residual risk, is the risk associated with individual stocks in a portfolio. This type of risk can be reduced through diversification.
2. How is Unsystematic Risk different from Systematic Risk?
While systematic risk influences a large number of assets due to widespread impact like changes in inflation, unsystematic risk affects a very small number of assets. Unsystematic risk is unique to a particular company or industry.
3. Can Unsystematic Risk be eliminated?
Yes, unsystematic risk can be virtually eliminated from a portfolio through diversification. The idea is to invest in various assets so that the possible negative performance of some is neutralized by the satisfactory performance of others.
4. What are the types of Unsystematic Risk?
There are generally two types of unsystematic risk – business risk and financial risk. Business risk is associated with the operations of the organization, whereas, financial risk is due to the capital structure of the company.
5. How does Unsystematic Risk impact investments?
Unsystematic risk impacts the investment in a company or sector. If not managed properly, this risk can lead to substantial losses for the investors. That’s why financial experts recommend diversification to reduce this risk.
Related Entrepreneurship Terms
- Company-specific Risk
- Idiosyncratic Risk
- Business Risk
- Non-systematic Risk
- Diversifiable Risk
Sources for More Information
Sure, here are four reliable sources where you can find more information about Unsystematic Risk:
- Investopedia: A comprehensive educational finance website that provides in-depth articles on various finance topics, including Unsystematic Risk.
- Corporate Finance Institute (CFI): A professional training organization that offers free resources on finance.
- Financial Management Pro: A resource offering detailed articles on many different aspects of finance.
- Khan Academy: An educational organization providing free lectures in various subjects, including finance.
