What Is Unsystematic Risk?

What Is Unsystematic Risk?

Let me explain unsystematic risk directly: it's a hazard that could harm just one company or an entire industry sector, without much effect on the wider investment world. You might hear it called diversifiable risk because you, as a smart investor, can lessen its impact by spreading your investments across various companies and sectors.

This is the opposite of systematic risk. Take airlines as an example—they deal with unsystematic risks like labor strikes, bad weather, or new regulations. But most industries face systematic risks such as economic slumps, rising fuel costs, or global disruptions.

Understanding Unsystematic Risk

You should know that unsystematic risk includes things like a new competitor stealing market share from your invested company, a regulatory shift cutting sales, a management change, or a product recall. It's basically the uncertainty baked into investing in a specific company or industry.

While you might predict some of these risks, it's tough to spot them all. For instance, if you're invested in healthcare, you could see a big policy change coming, but not know exactly how it'll play out for companies and customers.

Other risks include strikes or lawsuit outcomes. Remember, this is diversifiable risk—you can wipe it out by diversifying your portfolio enough. There's no direct formula for it; you figure it by subtracting systematic risk from total risk.

Types of Unsystematic Risk

Let's break down the types. Business risk comes from internal or external factors affecting operations. Say a company plans a new factory but faces construction delays—that's an internal risk that could erode its edge.

Financial risk ties to how a company structures its capital. It needs the right mix of debt and equity to grow and pay bills. A poor structure might lead to shaky earnings or cash flow, even halting trading. When rates rise, companies with low-yield debt might struggle to swap it for better options without losses.

Operational risk stems from unexpected events like supply chain failures or overlooked manufacturing errors. A security breach could leak customer data to hackers. These are day-to-day risks from flawed procedures, systems, or staff. For example, a refinery leak could halt production, cutting income until fixed.

Strategic risk happens when a company sticks to outdated products in a fading industry without a pivot plan, or picks a bad partner that damages prospects. In the auto world, lagging on electric vehicles puts you at serious strategic risk.

Legal and regulatory risk arises from law or rule changes that raise costs or add barriers. If the FDA bans a drug, that's regulatory risk for its maker. It could also involve contract errors, lawsuits, or violations. A drastic change, like the potential TikTok ban unless sold, could shut down operations entirely.

Unsystematic Risk vs. Systematic Risk

Total investment risk is unsystematic plus systematic. Unsystematic is company- or industry-specific, while systematic links to the whole market, often called market risk. It comes from broad factors, not individual picks.

Systematic risks include rate hikes, recessions, or inflation. You measure it with beta, showing how volatile a stock or portfolio is against the market. Company risk is harder to quantify. Both can be managed somewhat—systematic through asset allocation, unsystematic via diversification.

Example of Unsystematic Risk

To see this in action, consider owning stocks from various industries and asset classes to blunt single-event impacts. If you only hold airline stocks, you're exposed to high unsystematic risk—like a strike tanking prices, even just the rumor of it.

Add unrelated stocks, say outside transportation, and you spread out those airline-specific issues. This diversification might extend to bonds for extra shield against stock swings. But no portfolio escapes systematic risk entirely, like rate changes or wars affecting everything.

Explain Unsystematic Risk Like I’m 5 Years Old

Investors check all risks in an asset to guess possible losses. Some risks hit everything, like a recession or rising rates—that's systematic risk. Unsystematic is just for one company or industry, like bad bosses, lawsuits, or weather messing up supplies. You can cut this by investing in lots of different businesses and fields.

What Are Examples of Unsystematic Risk?

Key examples include poor management, weak business models, cash shortages, rule changes, or strikes.

What Is the Difference Between Systematic Risk and Unsystematic Risk?

Systematic risk can't be diversified away and hits the whole market, like inflation or rate risks. Unsystematic can usually be reduced through diversification.

What Are Types of Unsystematic Risk?

The five types are business, financial, operational, strategic, and legal/regulatory risk.

How Is Unsystematic Risk Measured?

In stocks, it's measured by unsystematic variance—subtract systematic variance from total variance.

The Bottom Line

Unsystematic risk is diversifiable, so buy shares in different companies and industries to reduce it. These risks are often company- or industry-specific and avoidable with a diversified portfolio. Systematic risk, however, is market-wide and beyond your control, like economic or political shifts. Unsystematic events, such as strikes or drug denials, affect specific firms.