Investing in securities markets inherently involves taking risks. In an investment context, risk means the uncertainty of achieving expected returns. Or, in other words, how the realized return may differ from what is expected.
Risks can be divided into categories according to their source. Unsystematic risks are those risks that are specific to investing in the securities of certain companies. This article will discuss unsystematic risk in more detail, provide examples of unsystematic risk, and explain what it means for individual investors.
Definition and Examples of Unsystematic Risk
Unsystematic risk is any type of risk that is specific to investing in a particular company or industry. Because unsystematic risk is dependent on factors that affect the issuer of the particular security you invest in, it is also called specific risk.
Unsystematic risk can also be further divided into two individual subcategories: business risk and financial risk.
Business risk is the uncertainty that arises due to the nature of the business activity that the company you are investing in is engaged in. For example, very speculative businesses or those that are in a new industry face a higher degree of uncertainty than businesses in more stable industries.
A business that is involved in developing new medicines, for example, faces higher business risk compared to a company that provides utility services. In this case, the company in a new or volatile industry has less certainty for success and guaranteed revenue.
Disruptions in the firm's operations, challenges from competitors, legal trouble, and a damaged reputation are all examples of ways that a company may face business risks. Another example includes a shortage in product manufacturing. All of these are specific risks because they negatively impact individual companies or sectors.
Firms must finance their assets in one way or another. Owners of companies may contribute all of the capital needed to fund the business, they can issue securities like stocks and bonds, or they can borrow money from a bank or other lender.
The way that a business chooses to fund its assets is called its capital structure. A firm's choice of capital structure is a source of risk as well.
When a business borrows money, it must repay that money. The required repayment of principal and interest creates an obligation for the firm that will reduce its net income. If a company is unable to repay that obligation, it may go out of business.
Firms that borrow money are often also subject to additional restrictions as a condition of the loan, such as providing collateral or limits on dividends.
- Alternate names: specific risk, diversifiable risk
How Does Unsystematic Risk Work?
Unsystematic risk, in combination with systematic risk, is part of the total risk of an investment portfolio.
Systematic risks are those that affect all companies in a market. Unlike systematic risk, unsystematic risk can be reduced specifically through diversification.
To reduce unsystematic risk through diversification, you need to create a portfolio of securities whose returns are negatively correlated. That simply means that the change in return of one security is offset by the change in return on another security. These changes offset each other, which reduces the overall change on the portfolio’s return from one period to the next. A well-diversified portfolio will also often protect you against a financial crisis, because risks will be reduced.
Reaching diversification can be challenging for investors. Investing in mutual funds may provide security, as this will give you small ownership of various financial instruments. Be aware, though, that a mutual fund investment does not always guarantee instant diversification, especially if the fund focuses only on one particular industry sector.
What It Means for Individual Investors
Individual investors can reduce their total investment risk by investing in securities whose returns are uncorrelated because doing so reduces unsystematic risk.
The reduction in unsystematic risk through diversification can reduce the variability in your portfolio returns. Since unsystematic risk can be reduced through diversification, but systematic risk cannot, that means an individual investor cannot completely eliminate risk and must still be willing to bear some risk if they want to invest.
Investors should understand how their investments are exposed to various types of risk, as well as the total level of risk they are taking in their portfolios. They need to be aware of how that risk relates to their own risk tolerance and affects their ability to achieve financial goals. If you have concerns about your investment strategy and the risk associated with it, consider consulting a financial advisor.
- Unsystematic risk is risk solely associated with a specific company or industry.
- Unsystematic risk can be reduced through diversification in your portfolio.
- Sources of unsystematic risk include business and financial risk.
- The total risk of an investment portfolio consists of unsystematic risks and systematic risks—those that affect all companies in a given market.