What is Unsystematic Risk?

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Contributor, Benzinga
September 13, 2023

Investing is a balancing act between risk and reward, where the aim is to take on types of risks that offer proportional returns. In this game, not all risks are created equal — some come with the promise of reward, while others are pitfalls you'd do well to avoid. 

One such pitfall lurking in the investment landscape is unsystematic risk, a type of risk that, unlike its systematic counterpart, doesn't offer additional rewards for taking it on. The name might seem complex, but the concept is actually relatively straightforward. 

Read on to demystify what unsystematic risk means for your investment strategy and how to effectively manage it.

Understanding Unsystematic Risk

To grasp the concept of unsystematic risk, let's first break down the term into its two components: unsystematic and risk.

  • Unsystematic: In a general sense, unsystematic refers to elements that are unique or specific to a particular situation, rather than being part of a larger, more predictable system. For example, a trait or factor that is specific to a single company, rather than the entire market. 
  • Risk: Risk is the possibility of loss. In the context of investing, risk refers to the uncertainty around the potential returns on an investment. It's the variability or volatility that an investment may experience, which could lead to either gains or losses.

Putting these two definitions together, unsystematic risk therefore refers to the uncertainty, volatility or possibility of loss tied to a specific asset that is independent of the market's overall movement. 

Think about it as the financial risk that you incur when investing in a single stock or a sector/industry of similar stocks. This is the risk that could affect one company or sector while leaving others relatively unscathed. 

Other names for unsystematic risk that you may have heard of include company-specific risk, diversifiable risk and idiosyncratic risk. These are all ways of expressing how the risk is unique to a particular asset or company.

Here's an example: Imagine you invest all your money in a company that produces smartphones. If that company releases a flawed product, faces a damaging lawsuit or gets hacked, the value of your investment will likely plummet. 

These are all considered unsystematic risks because they are unique to that particular smartphone company and wouldn't necessarily affect a different company in the same industry, let alone companies in other sectors.

If you'd diversified your portfolio by investing in multiple companies across various industries, like one that also produces fertilizer and another that drills for oil, the unsystematic risks specific to the smartphone company would have a much smaller impact on your portfolio. 

Types of Unsystematic Risk

Let's delve into the various types of unsystematic risks that investors should be aware of. Keep in mind that this list is intended to give you a general understanding via broad categories — the actual universe of unsystematic risks is large and can vary from company to company. 

Business Risk

Business risk is a broad category that deals with various unsystematic risks that could directly impact how effectively a company can operate and achieve its objectives. The various ways business risk can manifest stem from how a company conducts its everyday activities. For example, disruptions like a supply chain breakdown or labor disputes are examples of business risk. 

Financial Risk

Financial risk is another facet of unsystematic risk that deals specifically with a company's capital structure and its ability to meet its financial obligations. This risk is rooted in the ways a company manages its capital and cash flow. Examples of financial risk factors include leverage, credit and liquidity risk. 

Leverage involves the use of borrowed funds to amplify returns, but it also increases the risk of substantial losses. If a company is highly leveraged, a small decline in revenue can lead to a large decrease in profitability, making the stock more volatile. 

Credit risk is associated with the possibility that a company may default on its obligations to lenders, such as bondholders, which would severely damage its financial standing and its stock price. 

Liquidity risk is related to a company's ability to quickly convert its assets into cash without a significant loss in value, and if a company has poor liquidity, it might struggle to meet short-term obligations and become insolvent. 

Companies are subject to different types of government regulation and legislation. If they run afoul of these, regulatory and legal risks can arise. 

Examples of regulatory risks include changing laws and industry-specific regulations. For instance, changes in environmental laws could necessitate costly operational changes for a manufacturing firm. A company in the healthcare sector could be severely affected if new laws alter the way medical billing is handled or if drug approvals become more stringent. 

On the other hand, legal risks could include pending or potential lawsuits, copyright issues or labor law disputes, each of which could impose heavy financial burdens on a company, damage its reputation or endanger its ability to continue operating in extreme cases.

Operational Risk

The Basel Committee on Banking Supervision defines operational risk as “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”  This is a broad umbrella category that encompasses a variety of different types of risk events.

One form of operational risk could be a cybersecurity incident where inadequate or failed internal IT processes leave a bank vulnerable to a cyberattack. A successful attack could lead to a substantial loss of customer data and financial assets and could significantly damage the institution's reputation.

Another example is human error, such as an employee mistakenly executing a trade that results in a massive financial loss. This risk represents a failure in both people and internal processes, which could be improved through better training, oversight and system checks.

Strategic Risk

Sometimes, unsystematic risks can come from the top. Mistakes in how corporate leadership and management plan or execute a company's strategy can cause losses for investors by compromising its competitive advantage or harming profitability. 

Unlike operational or financial risks, which might be considered more tactical in nature, strategic risk stems from a failure in long-term planning and decision-making at the highest level of the organization. They involve poor decisions made at the C-suite or board level that have the power to fundamentally shape the outlook of the company.

Strategic risks tend to come into play when a company must make a high-stakes strategic decision choice, such as entering a new market, launching a new product or undergoing a merger or acquisition. 

If these strategic decisions turn out to be poor ones — for example, if a company overestimates the demand for a new product or misunderstands a foreign market it enters — substantial financial losses and damage could affect the company's brand.

Example of Unsystematic Risk

A compelling real-world example that illuminates the nature of unsystematic risk is the collapse of Enron Corporation in 2001, still taught in business schools today. 

This energy company was once considered to be a high-growth and innovative firm. However, its dramatic downfall resulted in it becoming one of the largest bankruptcies in U.S. history and wiped out billions in shareholder value.

The primary unsystematic risks that led to Enron's implosion were deeply rooted in financial malfeasance and regulatory issues. Financially, Enron employed complex accounting tricks to keep debt off its balance sheet while inflating earnings, deceiving investors. 

These activities were more than risky; they were fraudulent and deliberately misleading to investors and regulators. When these accounting irregularities were finally exposed, the financial risk materialized as the company’s stock price plummeted.

Simultaneously, Enron faced severe regulatory and legal risks. Its deceptive financial practices drew the attention of regulatory bodies and led to multiple investigations. The resulting legal actions were the final nail in the coffin for Enron. High-ranking executives were tried and convicted, and the regulatory backlash led to new compliance requirements for publicly traded companies, such as the Sarbanes-Oxley Act.

For investors, the collapse of Enron was a cataclysmic event that exemplified the devastating potential of unsystematic risk. Those who had not diversified their portfolios and were heavily invested in Enron shares, such as its employees participating in stock compensation plans, incurred monumental losses. 

Today, the Enron debacle remains a cautionary tale, emphasizing the need for due diligence in assessing unsystematic risks like financial and regulatory risks when investing in any single company, while diversifying to mitigate them.

Assessing and Managing Unsystematic Risk

While it's impossible to eliminate all forms of risk, certain strategies can minimize your exposure to unsystematic risk that is unique to individual companies.

The easiest way to do this is via diversification. In investing, this practice involves spreading out your capital between many different stock sectors, geographies and market cap sizes.

For example, if you're heavily invested in the technology sector, you might consider diversifying by adding healthcare or consumer staples stocks to your portfolio. This action reduces your susceptibility to events that disproportionately affect one industry or company.

Beyond diversification, other risk management techniques include hedging, which involves using financial instruments like options to offset potential losses and setting stop-loss orders, which automatically sell a stock if its price falls to a certain level.

Finally, for the stock-pickers out there, conducting thorough analysis and research into a company before investing is also pivotal in managing unsystematic risk. 

This process includes not only reviewing a company's financial statements but also understanding its competitive landscape, governance structure and any potential regulatory or legal risks it may face. Analyzing a company's historical performance, management expertise and strategic planning can provide valuable insights into its ability to manage risks effectively.

Systematic Risk vs. Unsystematic Risk

While diversification is a powerful tool for minimizing unsystematic risk, it's important to understand that it doesn't work for unsystematic risk's cousin, systematic risk. 

Systematic risk is unavoidable and is inherent to the entire market or market segment. It's a part and parcel of investing in any market and includes risks arising from macroeconomic factors such as inflation, political instability and changes in interest rates. 

Unlike unsystematic risk, which is specific to a particular company or industry, systematic risk affects all assets and cannot be mitigated by diversifying your portfolio.

Unsystematic risk is a complex but manageable part of investing. By employing strategies like diversification and hedging, along with rigorous research and analysis, investors can mitigate the impact of unsystematic risk and make more informed investment choices. 

A well-thought-out approach to managing these risks can significantly improve the odds of achieving a favorable investment outcome. When unsystematic risk is managed properly, investors have greater assurance that they're being paid fairly for the risk they do assume. 

Frequently Asked Questions 

Q

Are investors compensated for unsystematic risk?

A

No, investors are not generally compensated for unsystematic risk because it is avoidable through diversification. By diversifying, investors can achieve a comparable return while reducing unsystematic risk related to any single asset. Therefore, the market does not offer a higher expected return as a reward for bearing unsystematic risk.

Q

How many companies to invest in to eliminate unsystematic risk?

A

A 1987 study published in The Journal of Financial and Quantitative Analysis titled “How Many Stocks Make a Diversified Portfolio?” concluded that to significantly reduce unsystematic risk, investors should invest in 30 to 40 stocks. Practically speaking, passive funds that track a broad market index like the S&P 500 are usually sufficient for eliminating unsystematic risk as they encompass hundreds of stocks from different sectors.

Q

Is unsystematic risk uncontrollable?

A

Unsystematic risk is not uncontrollable; it can be mitigated or even eliminated through proper diversification. By holding a well-diversified portfolio, investors can reduce their exposure to the firm-specific risks that any single individual company poses

About Tony Dong

Tony Dong, MSc, CETF®, is a seasoned investment writer and financial analyst with a wealth of expertise in ETF and mutual fund analysis. With a background in risk management, Tony graduated from Columbia University in 2023, showcasing his commitment to continuous learning and professional development. His insightful contributions have been featured in reputable publications such as U.S. News & World Report, USA Today, Benzinga, The Motley Fool, and TheStreet. Tony’s dedication to providing valuable insights into the world of investing has earned him recognition as a trusted source in the finance industry. Through his writing, he aims to empower investors with the knowledge and tools needed to make informed financial decisions.