Unsystematic risk is distinctive to a particular company or sector. It is also called nonsystematic risk, unique risk, diversifiable risk, or residual risk. Unsystematic risk can be decreased in the context of an investment portfolio by diversification. On the other hand, systematic risk is inherent in the market. In this article, we’ll look at the difference between systematic risk and unsystematic risk, with examples.
What is Unsystematic Risk?
Unsystematic risk is defined as the uncertainty that comes with investing in a company or sector. A new rival in the market with the potential to capture considerable market share from the company invested in, a legislative change (which could reduce firm sales), a change in management, or a product recall, are all examples of unsystematic risk.
Some types of unsystematic risk may be anticipated by investors. However, it is practically impossible to be aware of all hazards. For example, a healthcare stock investor may be aware that a major shift in health policy is on the horizon, but may not fully understand the specifics of the new regulations and how companies and customers will respond.
Strikes, the outcomes of court proceedings, or natural disasters are further examples of unsystematic risk. This risk is also characterized as a diversifiable risk because it can be reduced by diversifying a portfolio adequately.
Unsystematic risk, like systematic risk, has many faces. And, an individual investor would have a tough time anticipating all of them. Nonetheless, they are typically divided into two categories:
#1. External Business Risk
External business risk is caused by the nature of the industry in which a firm works. In other words, it is related to investors’ general attitude toward a given business and their expectations about how hazardous that industry is.
Food, healthcare, and heavy manufacturing are examples of more stable industries and, as a result, organizations with reduced business risks. Similarly, industries and organizations that develop and change quickly might be more unpredictable. As a result, they’re riskier to invest in – consider technology, finance, or energy.
The level of risk in a certain industry is frequently reflected in the value of the companies in that industry. Stocks that are more stable tend to rise at a slower rate. On the other hand, riskier industries and companies often demonstrate a more fast, unpredictable value dynamic.
#2. Internal Business Risk
Internal business risk impacts single companies rather than industries and stems from the internal affairs and performance of a company.
Such hazards are notoriously difficult for investors to identify. On the one hand, you should be concerned only if they originate from a corporation in which you have a stake. On the other hand, it is not always possible for an investor to learn what is going on behind the scenes of a company in which they have invested.
This elusiveness is due in part to the fact that there are numerous sorts of internal business risks, all of which have about the same ability to disrupt the firm’s value as well as the value of your investment in this organization.
Types of Unsystematic Risk
#1. Business Risk
Internal and external difficulties can both pose a risk to a company’s operations. Internal risks are linked to operational efficiencies. For example, failure by management to obtain a patent to protect a novel invention would be an internal risk because it could result in a loss of competitive advantage. An example of external business risk is the Food and Drug Administration (FDA) banning a specific drug that a company sells.
#2. Financial risk
Financial risk has to do with a company’s capital structure. To continue to grow and meet its financial obligations, a company must maintain an optimal level of debt and equity. A shaky capital structure can lead to erratic earnings and cash flow, which can prevent a company from trading.
#3. Operational Risk
Unexpected or negligent events, such as a supply chain breakdown or a critical error being overlooked in the manufacturing process, can result in operational risks. A security breach could expose confidential customer information or other types of critical proprietary data to criminals.
We often associate operational risk with operations and the possibility of failed systems or procedures. These are the risks for day-to-day operations, and they can be caused by breakdowns in internal procedures, whether they are related to systems or employees.
#4. Risk in Strategic Management
Strategic risk arises when a corporation finds itself caught selling goods or services in a failing industry without a solid plan to evolve the company’s offerings. A corporation may also face this risk if it enters into a poor collaboration with another firm or competitor, which harms its future growth possibilities.
#5. Legal and Regulatory Risk
This is the risk that a change in laws or regulations will harm a business. These modifications may raise operational expenses or impose new legal requirements. More dramatic legal or regulatory changes can potentially put a business out of business. Other sources of legal risk include contract problems and law infractions.
An Example of Unsystematic Risk
Investors will be less affected by single occurrences if they own a diverse portfolio of firm stocks from various industries, as well as other forms of assets from various asset classes, such as Treasuries and municipal securities.
For example, an investor who only owned airline equities would be exposed to a high level of unsystematic risk (also known as idiosyncratic risk). They would be susceptible if, for example, airline staff went on strike. This occurrence has the potential to temporarily depress airline stock prices. The mere expectation of this news might jeopardize their portfolio.
This investor would spread out air-travel-specific concerns by adding uncorrelated positions to their portfolio, such as stocks outside of the transportation business. In this scenario, unsystematic risk impacts not only certain airlines but also a number of businesses, such as significant food corporations, with which many airlines do business. In this approach, the investor could diversify away from public stocks entirely by adding US Treasury Bonds as further protection from stock market swings.
However, even a well-diversified asset portfolio cannot eliminate all risks. The portfolio will still be vulnerable to systematic risk, which refers to the market’s overall uncertainty and includes interest rate changes, presidential elections, financial crises, wars, and natural disasters.
Unsystematic Risk Vs Systematic Risk
Before we compare a systematic risk and an unsystematic risk, let’s know what a systematic risk is.
What Is Systematic Risk?
Systematic risk is the risk we link to the mechanics of the entire financial market. In other words, it’s what investors mean when they mention “market volatility” or “macroeconomic issues” that could harm their assets.
The majority of systematic risk is unpredictable and uncontrollable. Its manifestations typically have an impact on financial markets beyond national borders and industries. As a result, systematic risk is seen as irreversible. That is, no matter how well-diversified your investment portfolio is, you cannot entirely protect it from systematic risk.
Systematic risk encompasses almost all economic, social, political, and environmental factors with the potential to affect entire financial markets. Finance specialists, on the other hand, often focus on three separate types of systematic risk that we most commonly encounter:
#1: The Risk of Interest Rates
The economic repercussions of changes in a financial market’s base interest rate — the rate at which commercial banks in a certain country borrow money from the central bank — are the source of interest rate risk.
The country’s central bank has the authority to adjust the basic interest rate whenever it wants, up to multiple times per year.
It is the responsibility of the Federal Reserve in the United States. It is the European Central Bank in EU countries that have chosen the euro as their currency.
Changes in the base interest rate affect not only the affordability of loans for the country’s inhabitants but also the value of many fixed-income securities, particularly government bonds.
When the base rate rises, the value of bonds issued when the previous, lower interest rate was in force falls – and vice versa.
As a result, if you’re thinking about investing in government bonds, you should assess how likely it is that the base interest rate will change in the near future and how that change would affect the value of your investments.
#2. Exchange Rate Risk
The implied volatility of currency exchange prices is connected with exchange rate risk. A rapid change in the exchange rate of a particular currency to the US dollar may have an impact on the value of your investments or revenue in that currency.
Exchange rate risk is typically a focus of multinational firms that conduct business in multiple countries, as well as investors that invest in overseas equities.
For example, if a firm operates in a country where the value of the local currency has been volatile or steadily dropping, the company may need to modify the pricing of its products or services in that country in order to remain competitive.
Alternatively, a company’s value may fall if the value of its host country’s currency falls.
Individual investors perceive exchange rate risk as being rather specialized. So, you shouldn’t be too concerned about it unless you regularly engage in international firms or currencies.
#3: The risk of Herd Mentality
Despite the fact that we commonly refer to herd mentality risk as general market risk, we will avoid using that phrase to avoid confusion. Since we also refer to systematic risk as market risk.
Herd mentality risk stems from the notion that markets often respond to systematic risk in a herd fashion. In other words, investors prefer to mimic one other’s decisions to buy or sell a certain item.
This results in a snowball effect:
A financial market’s performance is deteriorating as a result of a systematic risk factor.
Investors begin to panic and sell their investments in an attempt to mitigate their losses.
Because of an oversupply, the value of the assets they are selling falls even further, dragging the entire market performance even lower.
The herd mentality risk accounts for the majority of market volatility and systematic risk. Sharp market declines can wipe out a significant amount of your profits, whether you invest in individual stocks, exchange-traded funds (ETFs), bonds, or other securities.
Unsystematic Risk vs Systematic Risk
The total risk of an investment is the sum of unsystematic risk and systematic risk. Unsystematic risk is a risk that is exclusive to a company or industry. On the other hand, systematic risk is a risk that is related to the overall market. Systematic risk is the risk of an investment portfolio that is not based on individual investments and is attributed to broad market variables.
Interest rate changes, recessions, and inflation are all examples of systematic risks. Systematic risk is frequently estimated using the beta, which gauges the volatility of a stock or portfolio in comparison to the overall market. Meanwhile, company risk is more difficult to quantify and calculate.
Risk management can help to mitigate both systematic and unsystematic risks. Asset allocation can help to decrease systematic risk, while diversification can help to limit unsystematic risk.
In Conclusion,
Unsystematic risk is diversifiable. This means that if you invest in multiple companies from different industries, you can lower this risk. Unsystematic risks are frequently associated with a particular company or industry. Thus, you can avoid them.
A non-diversifiable risk or market risk is a systematic risk. These are aspects over which the firm or investor has no influence, such as economic, political, or societal considerations. Microeconomic factors that affect businesses, on the other hand, are unsystematic risks.
Unsystematic Risk FAQs
Why is it called unsystematic risk?
It is called unsystematic risk because it is specific to a particular business or industry. Specific risk, nonsystematic risk, residual risk, and diversifiable risk are other terms for it.
What is the difference between systematic and unsystematic risk?
Systematic risk is the possibility of a loss connected with the entire market or segment. Unsystematic risk, on the other hand, is linked to a single sector, segment, or security. Systematic risk is unpredictable in nature since it occurs on a broad scale and involves several components.
