Updated July 14, 2023
Definition of Unsystematic Risk
Unsystematic risk, also known as idiosyncratic risk, pertains to the company or industry but doesn’t affect the broader market or the economy as a whole. Therefore this risk is considered to be diversifiable because by adding the stock of other companies in the industry or different industries to the investment portfolio, this risk can be diversified away, if not completely eliminated.
Explanation
There are two kinds of risks in the investment in any security, broadly categorized as Systematic and Unsystematic risks. If the economy faces recession, all companies face slowing returns or even incur losses. Such a risk is known as systematic risk, and the same can’t diversify away.
However, suppose one company in the industry has taken an illogically higher amount of debt which is way beyond the industry average. Then this industry has a very heavy interest burden on its profits, which might even result in leaving no profits for the company’s shareholders. Such risks can avoid by either not investing in such stock or adding other stocks with lower debt in their capital structure. This risk is known as Unsystematic risk.
Types of Unsystematic Risk
There can be various ways of classifying the unsystematic risks, but each of these more or less covers the same kinds of risks using different terminology.
1. Business Risk
This includes company-specific risks such as the company’s operational efficiency, for example, if the company has a very high investment in inventory. Still, the units sold of their product are very low due to consumers preferring another brand. In such a case, the amount of inventory the company should hold must be lower than what it is holding. For example, there are external sources, the government imposing the rule that a certain patent life-saving drug’s formula should come under public domain so that the low-cost generic version of the same can be made; this would lead to a reduction in the company’s profits.
2. Financial Risk
This is an example of a nonsustainable capital structure, where the company is overburdened with debt. Therefore the company might face heavy interest liability situations when it is incurring losses as the interest on the debt is payable even if it is not profitable. However, high debt can have certain benefits because the interest is tax-deductible.
3. Operational Risk
Suppose there is a technological failure in a company where the company cannot generate computerized bills or online bills for its remote buyers, and therefore, the company may lose sales for the time during which the system is being repaired.
4. Strategic Risk
The company’s location away from the port area, initially chosen due to the anticipation of predominantly domestic demand, can result in significant freight charges as its products gain substantial demand in global markets. In such a situation, the companies located near the ports have a strategic advantage over this company.
5. Legal or Regulatory Risks
Suppose the government imposes a higher tax rate on tobacco products as it categorizes them as demerit goods; this would reduce demand and profits if the entire tax can’t pass on to the consumers.
Benefits of Unsystematic Risk
- Easy to Diversify: Unsystematic risk can diversify by including more securities in the portfolio; therefore, it is easier to eliminate the same than unsystematic risk. We can completely avoid it by not investing in security, while a certain kind of systematic risk can’t be avoided.
- Impacted by Controllable Factors: Unsystematic risk can avoid by improving internal controls, such as not blocking enough in the inventory if that is the requirement of the hour or by improving the capital structure, but systematic risk can’t be so easily controlled.
Limitations of Unsystematic Risk
- Unpredictable: Unsystematic risk effect by a number of factors, and therefore investors may not be able to predict what can cause the same and which stock it will affect; therefore, it becomes a barrier in making the investment decision, and ultimately investors will make a judgment call for that.
- Not Easily Found Out: Internal factors primarily cause unsystematic risk, and it is not always possible to determine what causes them through publicly available information. Therefore, investors may not always be able to quantify, as happened in the case of Enron, which committed several accounting frauds which didn’t see the public light till the company finally collapsed. And therefore, it is difficult for a staggered investor to find such problems until it is too late to repair them.
Systematic Risk vs Unsystematic Risk
- Meaning: Unsystematic risk is specific to a particular company or security, such as the risk of the company’s plant being located in an area that experienced a natural calamity, such as an earthquake. Other competing companies would not experience the losses experienced by this company due to this natural calamity, while the broader market faces systematic risks.
- Calculation: The measurement of systematic risk involves calculating the stock’s beta in relation to the market. This beta is determined by regression analysis or methods like the pure-play approach. However, there is no formula for calculating unsystematic risk because it can’t be generalized. Only approximate calculation can be done by subtracting the systematic risk from the total risk of the stock.
- Diversification: Systematic Risk can’t be diversified, while Unsystematic risk can be.
- Factors Affecting: Internal or controllable factors cause unsystematic risk, while external non-controllable factors cause systematic risk.
- Remedy: The remedy for systematic risk is to engage in asset allocation, which entails deciding on investing or not investing in certain assets. On the other hand, portfolio diversification is the solution for unsystematic risk, involving adding different securities from the same industry.
Conclusion
Therefore, we can understand that unsystematic risk is diversifiable and doesn’t impact the economy or the broader market. It can reduce, if not eliminate, by adding different securities of the same industry. Unlike the causes of systematic risk, the causes of unsystematic risk are company-specific. They can control by improving the internal controls systems, such as the operation of financial efficiency.
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