What is Unsystematic Risk
Unsystematic risk is unique to a specific company or industry. Also known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," in the context of an investment portfolio, unsystematic risk can be reduced through diversification.
BREAKING DOWN Unsystematic Risk
Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. Types of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, and/or a product recall.
While investors may be able to anticipate some sources of unsystematic risk, it is impossible to be aware all or when/how these might occur. For example, an investor in healthcare stocks may be aware that a major shift in health policy is on the horizon, yet she/he cannot know in advance the particulars of the new laws and how companies and consumers will respond. The gradual adoption and then potential repeal of the Affordable Care Act, first written into law in 2010, has made it very challenging for some investors in healthcare stocks to anticipate and place confident bets on the direction of the industry and/or specific companies.
Example of Unsystematic Risk
By owning a variety of company stocks across different industries, as well as by owning other types of securities in a variety of asset classes, such as Treasuries and municipal securities, investors will be less affected by single events. For example, an investor, who owned nothing but airline stocks, would face a high level of unsystematic risk. She would be vulnerable if airline industry employees decided to go on strike, for example. This event could sink airline stock prices, even temporarily. Simply the anticipation of this news could be disastrous for her portfolio.
By adding uncorrelated holdings to her portfolio, such as stocks outside of the transportation industry, this investor would spread out air-travel-specific concerns. Unsystematic risk in this case affects not only specific airlines but also several of the industries, such as large food companies, with which many airlines do business. In this regard, she could diversify away from public equities altogether by adding US Treasury Bonds as an additional protection from fluctuations in stock prices.
Even a portfolio of well-diversified assets cannot escape all risk, however. The portfolio will still be exposed to systematic risk, which refers to the uncertainty that faces the market as a whole and includes shifts in interest rates, presidential elections, financial crises, wars, and natural disasters.