Definition and Characteristics
Unsystematic risk, also known as company-specific risk, specific risk, diversifiable risk, idiosyncratic risk, or residual risk, refers to the risk that is inherent to a particular company or industry. It arises from factors that are specific to a particular company, such as management decisions, sales, market share, product recalls, labor disputes, and name recognition. Unlike systematic risk, which affects the broader market or an entire asset class, unsystematic risk is specific to individual securities or a particular industry.
Key Facts
- Unsystematic risk, also known as company-specific risk, specific risk, diversifiable risk, idiosyncratic risk, or residual risk, refers to the risk that is inherent to a particular company or industry.
- Unsystematic risk arises from factors that are specific to a particular company, such as management decisions, sales, market share, product recalls, labor disputes, and name recognition.
- Unlike systematic risk, which affects the broader market or an entire asset class, unsystematic risk is specific to individual securities or a particular industry.
- Unsystematic risk can be mitigated through portfolio diversification. By spreading investments across different companies and industries, the impact of unsystematic risk on the overall portfolio can be reduced.
- Diversification involves investing in a variety of assets that are not highly correlated with each other. By including assets with different risk profiles, an investor can reduce the impact of unsystematic risk on their portfolio.
- Studies have shown that adding a modest number of stocks from different sectors to a single-stock portfolio can significantly reduce unsystematic risk. Most unsystematic risk can be eliminated if the portfolio is comprised of 20 or more stocks from several different sectors.
- The risk reduction achieved through diversification is measured by the standard deviation of a portfolio’s returns. As the number of stocks in a portfolio increases, the standard deviation and the associated unsystematic risk decrease.
Diversification as a Mitigation Strategy
Unsystematic risk can be mitigated through portfolio diversification. By spreading investments across different companies and industries, the impact of unsystematic risk on the overall portfolio can be reduced. Diversification involves investing in a variety of assets that are not highly correlated with each other. By including assets with different risk profiles, an investor can reduce the impact of unsystematic risk on their portfolio.
Studies have shown that adding a modest number of stocks from different sectors to a single-stock portfolio can significantly reduce unsystematic risk. Most unsystematic risk can be eliminated if the portfolio is comprised of 20 or more stocks from several different sectors.
Measuring the Impact of Diversification
The risk reduction achieved through diversification is measured by the standard deviation of a portfolio’s returns. As the number of stocks in a portfolio increases, the standard deviation and the associated unsystematic risk decrease.
Conclusion
Unsystematic risk is a significant factor for investors to consider when making investment decisions. By understanding the nature of unsystematic risk and implementing appropriate diversification strategies, investors can reduce the impact of this type of risk on their portfolios.
References
- Investopedia: Unsystematic Risk
- ICFS: Systematic and Unsystematic Risk
- Wall Street Prep: Unsystematic Risk
FAQs
What is unsystematic risk?
Unsystematic risk is the risk that is specific to a particular company or industry. It arises from factors that are specific to a particular company, such as management decisions, sales, market share, product recalls, labor disputes, and name recognition.
Why is unsystematic risk diversifiable?
Unsystematic risk is diversifiable because it is specific to individual companies or industries. By investing in a variety of companies and industries, investors can reduce the impact of unsystematic risk on their overall portfolio.
How does diversification reduce unsystematic risk?
Diversification reduces unsystematic risk by spreading investments across different companies and industries. This means that the impact of any one company or industry on the overall portfolio is reduced.
What is the relationship between the number of stocks in a portfolio and unsystematic risk?
As the number of stocks in a portfolio increases, the unsystematic risk of the portfolio decreases. This is because the unsystematic risk of individual stocks is averaged out across the portfolio.
How much unsystematic risk can be eliminated through diversification?
Most unsystematic risk can be eliminated if the portfolio is comprised of 20 or more stocks from several different sectors.
How is the risk reduction achieved through diversification measured?
The risk reduction achieved through diversification is measured by the standard deviation of a portfolio’s returns. As the number of stocks in a portfolio increases, the standard deviation and the associated unsystematic risk decrease.
What are some examples of unsystematic risk?
Examples of unsystematic risk include:
* A new competitor entering the market
* A change in consumer preferences
* A product recall
* A labor strike
* A natural disaster
What are some examples of how diversification can reduce unsystematic risk?
Examples of how diversification can reduce unsystematic risk include:
* Investing in stocks from different industries
* Investing in stocks from different countries
* Investing in stocks of different sizes
* Investing in stocks with different risk profiles