- Unsystematic risk is company-specific risk or idiosyncratic risk which is not spread to the wider universe or market.
- Unsystematic risk can be controlled through diversification; therefore, it is also called diversifiable risk.
Examples are loss suffered from events like death of key persons in the company, fraud committed in or by the company, or some upset caused restricted to the company.
What is Unsystematic Risk?
Unsystematic risk is company-specific risk or idiosyncratic risk which is not spread to the wider universe or market. It is also known as diversifiable risk, specific risk or residual risk. In the context of investments, investors are generally able to gauge possibilities of unsystematic risks but it is not possible to be totally aware regarding when and how it will happen.
What are some of the examples of unsystematic risk?
Unsystematic risk includes loss suffered from events like death of key persons in the company, fraud committed in or by the company, or some upset caused that is restricted to the company.
An example from the investment world is let’s say if transport operatives have a strike, then an investor who only holds stock in the transport industry would have to face high unsystematic risk.
Factors causing Unsystematic (Company Specific) Risk?
Factors causing company-specific risk can be divided as:
1. Business Risk
Many external and internal issues can cause business risk. Banning of a particular product that a company sells to legal authorities of a country is an example of external risk. Operational inefficiency and miscommunication of important information constitutes internal risk.
2. Financial Risk
Financial risk deals with risk due to the debt equity ratio (or capital structure) of the company. An inefficient capital structure may hinder growth and may increase chances of financial distress.
3. Strategic Risk
Strategic Risk occurs when a company lacks proper strategic planning before execution of important events.
4. Operational Risk
Operational Risk occurs due to negligent or unforeseen events like a supply chain breakdown or negligence of a critical process in the manufacturing process.
5. Legal Risk
These risks include lawsuits filed against the company, changes in government regulations having major impact on a particular company etc.
How do you control Unsystematic Risk?
Diversification is the one way used to reduce unsystematic risk of a portfolio. Having investments with the right mix of safer and riskier securities in a variety of industries help in controlling the unsystematic.
A disadvantage of diversification is that it decreases overall returns for the investors as both profits and losses cancel each other out.
However, unsystematic risk can also be positive for a company, with certain occurrences such as a competitor going bankrupt, and products or marketing communication going viral.
An investor can protect themselves from unsystematic risk by diversifying their portfolio well. A diversified portfolio mostly has to deal with systematic or market risk when choosing the asset classes.