Because investors can eliminate unsystematic risk for free by diversifying their portfolios, they

Written by Amr Tenney | Jun 18, 2022

Unsystematic risk is the flip side of the two primary risks investors face. The other risk is called systematic risk. Understanding the difference between these two risks means understanding why some risks can’t be reduced/eliminated from a portfolio while other risks can. 

Diversification is often the go-to strategy for reducing portfolio risk. While diversification can reduce some risks, it can’t reduce all risks. Read further to see why.

Unsystematic Vs. Systematic Risk

Unsystematic risk is also called idiosyncratic or company-specific risk. This is a risk inherent to a company rather than the broader market. For example, a company can experience an adverse event that causes its stock to drop while the overall market is moving up.

Systematic risk means the same company can be doing well but have its stock drop because the overall market is dropping. Even though the company is doing well and under normal conditions would probably see its stock rise because overall sentiment has changed, and the company experiences systematic or market risk.

Investors have tools available to deal with unsystematic risk. However, there isn’t anything investors can do to manage systematic risk. Systematic risk is always present in virtually every investment. U.S. government bonds, savings accounts, and CDs may be said not to have any systematic risk because the government virtually guarantees the return of principal. 

Real estate, stocks, and corporate bonds do not have any guarantees on the return of principal. Events in the overall market can cause these investments to lose some or all of their value. 

Diversification and Unsystematic

Unsystematic risk occurs when a company files for bankruptcy, launches a product that fails in the marketplace, or takes on a project with large cost overruns. All can cause the company's value to decrease, adversely affecting investors.

Investors can manage unsystematic risk by not investing in risky companies and diversifying their portfolios. Diversification doesn't just mean adding more stocks to a portfolio. These stocks need to be uncorrelated. Meaning, that stock prices do not move together, and the companies are in different sectors. 

The above is an example of portfolio diversification and doesn't remove the possibility that some company experiences a negative event that causes their stock price to drop. Instead, diversification limits the impact of one stock on the entire portfolio. 

Let's say an investor has 30 stocks in their portfolio. One of the investor's holdings announces a major recall for its product. The stock plummets on the news. Because the investor is holding close to equal weightings of all companies, the single stock doesn't cause the portfolio's value to plummet with it. Instead, the portfolio sees only a small change in its value. While one stock is dropping, others are rising.

Can unsystematic risk be eliminated? The only way to eliminate unsystematic risk is to not invest. It's difficult to foresee when a company might experience an adverse event and then anticipate what the market's reaction will be to it. So no, investors cannot eliminate unsystematic risk. But investors can manage it through diversification.

Unsystematic risk is the risk that is unique to a specific company or industry. It's also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk. In the context of an investment portfolio, unsystematic risk can be reduced through diversification—while systematic risk is the risk that's inherent in the market.

• Unsystematic risk, or company-specific risk, is a risk associated with a particular investment.
• Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk.
• Once diversified, investors are still subject to market-wide systematic risk.
• Total risk is unsystematic risk plus systematic risk.
• Systematic risk is attributed to broad market factors and is the investment portfolio risk that is not based on individual investments. 

Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. Examples of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, or a product recall.

While investors may be able to anticipate some sources of unsystematic risk, it is nearly impossible to be aware of all risks. For instance, an investor in healthcare stocks may be aware that a major shift in health policy is on the horizon, but may not fully know the particulars of the new laws and how companies and consumers will respond.

Other examples of unsystematic risks may include strikes, outcomes of legal proceedings, or natural disasters. This risk is also known as a diversifiable risk since it can be eliminated by sufficiently diversifying a portfolio. There isn't a formula for calculating unsystematic risk; instead, it must be extrapolated by subtracting the systematic risk from the total risk.

Both internal and external issues may cause business risk. Internal risks are tied to operational efficiencies. For example, management failing to take out a patent to protect a new product would be an internal risk, as it may result in the loss of competitive advantage. The Food and Drug Administration (FDA) banning a specific drug that a company sells is an example of external business risk.

Financial risk relates to the capital structure of a company. A company needs to have an optimal level of debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow that could prevent a company from trading.

Operational risks can result from unforeseen or negligent events, such as a breakdown in the supply chain or a critical error being overlooked in the manufacturing process. A security breach could expose confidential information about customers or other types of key proprietary data to criminals. 

Operational risk is tied to operations and the potential for failed systems or policies. These are the risks for day-to-day operations and can result from breakdowns in internal procedures, whether tied to systems or employees.

A strategic risk may occur if a business gets stuck selling goods or services in a dying industry without a solid plan to evolve the company's offerings. A company may also encounter this risk by entering into a flawed partnership with another firm or competitor that hurts their future prospects for growth. 

Legal and regulatory risk is the risk that a change in laws or regulations will hurt a business. These changes can increase operational costs or introduce legal hurdles. More drastic legal or regulation changes can even stop a business from operating altogether. Other types of legal risk can include errors in agreements or violations of laws.

Total risk for investments is unsystematic risk plus systematic risk. Unsystematic risk is a risk specific to a company or industry, while systematic risk is the risk tied to the broader market. Systematic risk is attributed to broad market factors and is the investment portfolio risk that is not based on individual investments. 

Types of systematic risks can include interest rate changes, recessions, or inflation. Systematic risk is often calculated with beta, which measures the volatility of a stock or portfolio relative to the entire market. Meanwhile, company risk is a bit more difficult to measure or calculate.

Systematic and unsystematic risks can be mitigated, in part, with risk management. Systematic risk can be reduced with asset allocation, while unsystematic risk can be limited with diversification. 

By owning a variety of company stocks across different industries, as well as by owning other types of securities in a variety of asset classes, such as Treasuries and municipal securities, investors will be less affected by single events.

For example, an investor, who owned nothing but airline stocks, would face a high level of unsystematic risk (also known as idiosyncratic risk). They would be vulnerable if airline industry employees went on strike, for example. This event could sink airline stock prices, even temporarily. Simply the anticipation of this news could hamper their portfolio.

By adding uncorrelated holdings to their portfolio, such as stocks outside of the transportation industry, this investor would spread out air-travel-specific concerns. Unsystematic risk, in this case, affects not only specific airlines but also several of the industries, such as large food companies, with which many airlines do business. In this regard, the investor could diversify away from public equities altogether by adding U.S. Treasury bonds as additional protection from fluctuations in stock prices.

Even a portfolio of well-diversified assets cannot escape all risk, however. The portfolio will still be exposed to systematic risk, which refers to the uncertainty that faces the market as a whole and includes shifts in interest rates, presidential elections, financial crises, wars, and natural disasters.

Key examples of unsystematic risk include management inefficiency, flawed business models, liquidity issues, or worker strikes.

Systematic risk is not diversifiable (i.e. cannot be avoided), while unsystematic can generally be avoided. Systematic risk affects much of the market and can include purchasing power or interest rate risk. 

There are five types of unsystematic risk—business, financial, operational, strategic, and legal/regulatory risk.

Unsystematic risk—when it comes to investing in stocks—can be considered the unsystematic variance. That is calculated by subtracting systematic variance from the total variance.

Unsystematic risk is diversifiable, meaning that (in investing) if you buy shares of different companies across various industries you can reduce this risk. Unsystematic risks are often tied to a specific company or industry and can be avoided. 

Systematic risk is a non-diversifiable risk or market risk. These factors are beyond the control of the business or investor, such as economic, political, or social factors. Meanwhile, microeconomic factors that affect companies are unsystematic risks.