What Is Unsystematic Risk? Definition and Examples
Understand unsystematic risk: the investment challenge unique to individual assets, and how it can be effectively managed.
Unsystematic risk is a specific type of investment risk that affects individual companies or particular industries. It represents the uncertainties unique to an asset, distinguishing it from broader market risks that impact all investments. Understanding this localized form of risk is important for investors assessing potential impacts on their portfolios.
Understanding Unsystematic Risk
Unsystematic risk is inherent to a particular company, industry, or asset, arising from internal factors or events specific to that entity. This type of risk is also known as specific risk, diversifiable risk, or company-specific risk. Its effects are constrained to certain securities or a specific industry, rather than influencing the entire market.
Common Sources of Unsystematic Risk
Various real-world scenarios can lead to unsystematic risk, impacting a single company or a narrow sector. A company’s product recall, for instance, directly affects that firm’s sales and reputation without necessarily impacting competitors. Labor strikes at a specific firm can disrupt its operations and supply chain, leading to production delays or losses.
The resignation of a key executive or adverse legal judgments against a single corporation can also introduce unsystematic risk by destabilizing leadership or imposing significant financial burdens. A new competitor entering a specific industry segment or changes in consumer preferences for a particular brand can threaten an individual company’s market share and profitability. These events are specific to the entity and do not broadly affect the entire economy.
Unsystematic Risk Compared to Systematic Risk
Systematic risk, often called market risk or non-diversifiable risk, affects the entire market or a large segment of it. Examples include economic recessions, changes in interest rates, or geopolitical events that influence all investments. This type of risk is inherent to the broader economy and financial markets, making it difficult to avoid through investment choices.
In contrast, unsystematic risk is specific to a company or industry. It arises from factors unique to a particular organization, industry, or market segment. While systematic risk impacts the market as a whole, unsystematic risk affects only specific stocks or a narrow group. Unsystematic risk can generally be mitigated, whereas systematic risk cannot be eliminated through diversification. Systematic risk is largely influenced by macroeconomic factors, while unsystematic risk is tied to company-specific issues.
The Role of Diversification
Diversification is a strategy designed to reduce the overall unsystematic risk within an investment portfolio. Because unsystematic risks are specific to individual assets or companies, combining various assets across different industries and geographies can spread this company-specific risk. By holding a mix of assets, the negative performance of one investment due to a company-specific event may be offset by the positive performance of others.
This approach ensures that if one asset underperforms, the entire portfolio is not significantly impacted, thereby reducing volatility. While diversification does not eliminate all investment risk, it can significantly reduce the impact of unsystematic risk on a portfolio’s returns.