Definition of Unsystematic Risk
Unsystematic risk, also known as the idiosyncratic risk, is pertaining to the company or industry but doesn’t affect the broader market or the economy as a whole, and 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.
There are two kinds of risks pertaining to investment in any security, and these are broadly categorized as Systematic and Unsystematic risks. If the economy as a whole faces recession, then all the companies in the economy face slowing returns or even incur losses. Such a risk is known as the systematic risk, and the same can’t be diversified 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 be avoided by either not investing in such stock or by adding other stocks that have a 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 operational efficiency of the company, for example, if the company has a very high investment in inventory, but the units sold of their product are very low due to consumers preferring some other brand. In such a case, the amount of inventory the company should hold must be lower than what it is actually holding. For example, there can be external sources, for example, the government imposing the rule that a certain patented 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 profits of the company.
2. Financial Risk
This is the example explained above of a nonsustainable capital structure, where the company is over burdened with debt, and therefore the company might face heavy interest liability situations when it is incurring losses as the interest on the debt is payable even if the company is not profitable. However, there can be certain benefits of high debt because the interest is tax-deductible.
3. Operational Risk
Suppose there is a technological failure in a company where if the company is not able to 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
If a company is located away from the port area because it expects that most of its demand will be domestic, but gradually its products are heavily demanded in the global markets, and therefore, the location might cause heavy freight charges. In such a situation, the companies which are 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, therefore, a reduction in profits if the entire tax can’t be passed on to the consumers.
Benefits of Unsystematic Risk
- Easy to Diversify: Unsystematic risk can be diversified by including more securities in the portfolio, and therefore, it is easier to get rid of the same than it is the case with 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 be avoided 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 is affected by a number of factors, and therefore investors may not be able to predict what can cause the same and which stock will it affect; therefore, it becomes a barrier in making the investment decision, and ultimately investors will take a judgment call for that.
- Not Easily Found Out: Unsystematic risk is caused due to internal factors most of the time, and what can cause them cannot always be known through the publicly available information, and therefore, investors may not always be able to quantify as it 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 out such problems till it is too late to repair them.
Systematic Risk vs Unsystematic Risk
- Meaning: Unsystematic risk is the risk specific to a particular company or security, such as the risk of the company’s plant being located in an area which 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 overall broader market faces systematic risks.
- Calculation: Systematic risk is measured through the beta of the stock with reference to the market, and this beta is calculated by regression analysis or methods such as the pure-play approach. However, there is no formula for the calculation of unsystematic risk because it can’t be generalized. An 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: Unsystematic risk is caused by internal or controllable factors, while external non-controllable factors cause systematic risk.
- Remedy: Cure for systematic risk is asset allocation that is investing or not investing in certain assets, while that for unsystematic risk is making portfolio diversification, that is, adding different securities of the same industry.
Therefore, we can understand that unsystematic risk is diversifiable and doesn’t impact the economy or the broader market as a whole. It can be reduced, if not eliminated, by adding different securities of the same industry in the market. Unlike the causes of systematic risk, the causes of unsystematic risk are company-specific and can be controlled by improving the internal controls systems, such as the operation of financial efficiency.
This is a guide to Unsystematic Risk. Here we discuss the definition and types of unsystematic risk along with benefits and limitations. You may also look at the following articles to learn more –