Specific risk is a risk that affects a minimal number of assets. Specific risk, as its name implies, relates to risks that are very specific to a company or small group of companies. This type of risk is the opposite of overall market risk or systematic risk. Specific risk is also referred to as “unsystematic risk” or “diversifiable risk.”
Breaking Down Specific Risk
An example of specific risk would be news that is specific to either one stock or a small number of stocks, such as a sudden strike by the employees of a company or a new governmental regulation affecting a particular group of companies. Diversification helps to reduce specific risk.
Two factors cause company-specific risk:
- Business Risk: Both internal and external issues may cause business risk. Internal risk relates to the operational efficiency of the business. For example, management failing to take out a patent to protect a new product would be an internal risk, as it may result in the loss of competitive advantage. The Food and Drug Administration (FDA) banning a specific drug that a company sells is an example of external business risk.
- Financial Risk: Financial risk relates to the capital structure of a company. A company needs to have an optimal level of debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow that could prevent a company from trading.
Reducing Specific Risk Through Diversification
Investors can reduce specific risk by diversifying their portfolios. Research conducted by prominent economist Harry Markowitz found that specific risk decreases significantly if a portfolio holds approximately 30 securities. The securities should be in different sectors so that stock- or industry-specific news does not affect the majority of the portfolio. For example, a portfolio might have exposure to the healthcare, basic materials, financial, industrial goods, and technology sectors. A mix of uncorrelated asset classes should also be included in a portfolio to reduce specific risk.
Investors could use exchange-traded funds (ETFs) to diversify their portfolios. ETFs can be used to track a broad-based index, such as the Standard & Poor’s 500 index (S&P 500), or follow specific industries, currencies, or asset classes. For example, investors could reduce specific risk by investing in an ETF that has a balanced allocation of asset classes and sectors, such as the iShares Core Moderate Allocation fund. This means that adverse news affecting a specific asset class or sector won’t have a material impact on the portfolio’s overall return.