What is Unsystematic Risk?
Unsystematic risk, alternatively referred to as specific risk, diversifiable risk, or residual risk, is unique to a specific company or industry rather than the general market or economy. This risk category is contingent upon factors that influence the performance, profitability, or operational dynamics of a particular business or sector.
Instances of non-systematic risk can originate from different factors, including but not limited to product recalls, regulatory modifications, legal disputes, labor strikes, or natural calamities. These events have the potential to detrimentally influence the financial position of a company or an industry without necessarily impacting the overall market.
How Unsystematic Risk Works
Unsystematic risk operates by impacting the returns of a security or portfolio in a manner that is not correlated with the overall movements of the market. For instance, events like lawsuits, product recalls, strikes, or management changes can negatively affect a company's stock price, regardless of how the market as a whole is performing. Similarly, if an industry is affected by new regulations, technological disruptions, shifts in consumer preferences, or natural disasters, these events can impact the performance of both the industry and the securities within it, irrespective of the prevailing market conditions.
Diversification is a cure to reduce or eliminate unsystematic risk. By spreading investments across different companies and industries, an investor can minimize their exposure to any single factor. Holding a variety of securities that are not affected by the same sources of risk helps reduce the overall volatility and variability of portfolio returns. This is because positive returns from some securities can offset the negative returns from others, resulting in a smoother and more stable return stream.
However, it is important to note that unsystematic risk cannot be completely eliminated. Certain factors may affect all companies or industries to some extent, such as inflation, interest rates, exchange rates, or political instability. These factors are known as systematic or market risk and cannot be diversified away. Systematic risk impacts the entire market or economy and is influenced by macroeconomic factors beyond the control of individual investors or companies. Managing systematic risk requires using hedging strategies, such as derivatives, or adjusting a portfolio's asset allocation by increasing the proportion of less risky assets, such as bonds or cash