Unsystematic risk, sometimes called specific risk or idiosyncratic risk, represents the type of investment risk that arises from issues unique to a single company or industry rather than the entire market. Examples include management changes, regulatory impacts, labor strikes, or product failures that affect only one business or a narrow group of companies.
This risk contrasts with systematic risk, which relates to broad market influences like economic recessions or geopolitical events that impact almost all securities to some extent. While you cannot eliminate systematic risk, unsystematic risk is largely avoidable through prudent investment strategies.
For example, a pharmaceutical company’s stock may plunge if a new drug fails clinical trials, while other drugmakers remain unaffected. Similarly, a data breach in a tech firm affects that company’s stock but not necessarily other industries such as finance or manufacturing.
Key Differences Between Unsystematic and Systematic Risk
| Feature | Unsystematic Risk | Systematic Risk |
|---|---|---|
| Also Known As | Specific risk, idiosyncratic risk, diversifiable risk | Market risk, undiversifiable risk |
| Scope | Affects individual company or industry | Affects entire market or economy |
| Examples | Lawsuits, recalls, strikes, management changes | Recessions, inflation, interest rate hikes, political instability |
| Control | Can be reduced by diversification | Cannot be diversified away |
| Impact | Specific to certain investments | Affects almost all investments |
Managing Unsystematic Risk Through Diversification
Diversification is the primary method to mitigate unsystematic risk. By spreading investments across multiple companies, industries, asset classes, and geographies, you reduce exposure to any single event impacting one business. For instance, holding a mix of stocks from the technology, healthcare, and energy sectors lessens the effect if one sector underperforms.
A diversified portfolio might include:
- Equities from various industries
- Bonds and fixed-income securities
- Real estate investment trusts (REITs) or other alternative assets
- Domestic and international stocks
This approach aligns with principles explained by the U.S. Securities and Exchange Commission, which notes that diversification is a technique to reduce portfolio risk by choosing a range of investments across categories (Investor.gov – Diversification).
Common Investor Pitfalls Related to Unsystematic Risk
- Concentration Risk: Over-investing in a single company or sector increases vulnerability to unsystematic risk.
- Overconfidence: Believing a company is immune to risks due to past success or size.
- Ignoring Small-Cap Risks: Smaller companies may carry higher idiosyncratic risks due to limited resources or market exposure.
- Over-Diversification: Spreading too thin without a strategy can dilute returns and complicate management.
Additional Considerations
Unsystematic risk also affects bonds and other fixed-income investments. For example, a corporate bond issuer facing financial distress might default, directly impacting bondholders. Understanding these risks helps investors construct portfolios that balance growth potential with risk mitigation.
Related Concepts
Explore topics such as Portfolio Diversification, Investment Diversification Strategy, and Business Risk to deepen your understanding.
Frequently Asked Questions
Can unsystematic risk be completely eliminated?
While significant reduction is achievable through diversification, it is virtually impossible to eliminate all unsystematic risk because each investment may have unique factors.
Is unsystematic risk the same as business risk?
Business risk is a component of unsystematic risk, referring specifically to operational or management risks within a company.
Does unsystematic risk apply to bonds?
Yes. Company-specific events can cause bond defaults or credit downgrades, impacting bondholders similarly.
Sources
- Investopedia, “Unsystematic Risk,” https://www.investopedia.com/terms/u/unsystematicrisk.asp
- U.S. Securities and Exchange Commission, “Diversification,” https://www.investor.gov/introduction-investing/investing-basics/diversification