Is Unsystematic Risk Diversifiable?

Investing involves risk, the possibility of losing money or not achieving expected returns. Understanding investment risks is important for any investor. Not all risks are identical; various strategies manage them effectively. Some risks can be reduced or eliminated through careful planning and portfolio construction, while others remain unavoidable.

Understanding Unsystematic Risk

Unsystematic risk, also known as specific or diversifiable risk, refers to uncertainties affecting a particular company, industry, or asset. These risks are unique to an individual investment and do not impact the broader market. Events causing unsystematic risk arise from internal factors related to a specific entity or sector, rather than macroeconomic conditions affecting all investments. Examples of events that generate unsystematic risk include a company product recall, a labor strike, a change in management, a lawsuit against an industry player, or localized supply chain disruptions. Such occurrences significantly impact the financial performance and stock price of the affected company or industry, without affecting other sectors or the overall economy.

The Concept of Diversification

Diversification is an investment strategy that spreads investments across various assets to reduce overall risk. This approach operates on the principle of not concentrating all investments in a single area. By combining different assets, investors aim to mitigate negative impacts if one performs poorly.

The mechanism of diversification relies on selecting assets that do not move in perfect alignment. When some assets in a portfolio experience a downturn, the positive or neutral performance of other assets can offset these losses. This balanced approach helps smooth overall returns of an investment portfolio over time.

Why Unsystematic Risk is Diversifiable

Unsystematic risk is diversifiable because the events that cause it are unique to individual companies or industries. When an investor holds a variety of different assets, the negative impact of an event affecting one specific asset is balanced by unaffected or positively performing assets within the same portfolio. This means that the risks specific to one company can be largely offset by the performance of others.

The effects of company-specific issues, such as localized supply chain disruptions or regulatory challenges, are confined to those particular investments. A sufficiently large and diverse portfolio can absorb these individual shocks, as losses in one segment are contained and do not spread across all holdings.

This contrasts with systematic risk, often called market risk, which stems from broader economic factors like inflation or interest rate changes affecting nearly all investments. Systematic risk cannot be eliminated through diversification because it impacts the entire market, making all investments vulnerable. However, unsystematic risk, being specific and localized, can be substantially reduced through proper diversification.

Implementing Diversification in a Portfolio

Investors can achieve diversification to mitigate unsystematic risk by spreading investments across different companies, industries, and asset classes. This strategy involves selecting securities that respond differently to various market conditions. For instance, an investor might hold stocks from technology, healthcare, and consumer goods companies.

Diversification can extend to different geographic regions, reducing exposure to economic downturns or regulatory changes in a single country. Investing in various asset classes, such as stocks, bonds, and potentially real estate or commodities, also enhances diversification. Mutual funds and Exchange Traded Funds (ETFs) offer accessible ways for investors to achieve broad diversification, as these vehicles inherently hold many different securities across various sectors and companies.