Unsystematic Risk

Understanding Unsystematic Risk

Unsystematic risk (also known as diversifiable risk, unique risk, company-specific risk, or idiosyncratic risk) is the risk that is specific to an individual company, industry, or investment. Unlike systematic risk, unsystematic risk CAN be eliminated through diversification.

The critical principle to understand is that investors are NOT compensated for bearing unsystematic risk. Because this risk can be eliminated simply by holding a diversified portfolio, the market does not reward investors for taking it. An investor who holds a concentrated portfolio is taking risk for which they receive no additional expected return.

CFP Exam Tip: The key distinction between systematic and unsystematic risk is compensation. Systematic risk = compensated (market risk premium). Unsystematic risk = NOT compensated (can be diversified away).

Types of Unsystematic Risk

1. Business Risk

Business risk is the risk that a company's operations will not generate sufficient revenue to cover its fixed operating costs. This risk stems from the nature of the business itself, including competition, product obsolescence, management quality, and operational efficiency.

Components of business risk:

• Industry competition and market position
• Product lifecycle and innovation risk
• Management competence and strategy
• Supply chain vulnerabilities
• Labor and operational issues

Example: A technology company faces business risk if a competitor introduces a superior product, making its offerings obsolete. A retail company faces business risk if consumer preferences shift away from its product categories.

2. Financial Risk (Leverage Risk)

Financial risk is the risk associated with a company's use of debt (leverage) to finance its operations. The more debt a company has, the greater its fixed interest obligations, and the higher the risk that it cannot meet these obligations during difficult times.

Key relationships:

• Higher debt-to-equity ratio = higher financial risk
• Fixed interest payments must be made regardless of business performance
• Leverage amplifies both gains and losses for equity holders

Example: Company A and Company B both have $1 million in assets. Company A is financed with 90% equity and 10% debt, while Company B uses 50% equity and 50% debt. During a recession, Company B faces much higher financial risk because it must still make interest payments even if revenues decline.

3. Liquidity Risk

Liquidity risk is the risk that an investor will not be able to buy or sell an investment quickly enough at a fair market price. Illiquid investments may need to be sold at a significant discount if the investor needs cash quickly.

Characteristics of less liquid investments:

• Thin trading volume
• Wide bid-ask spreads
• Extended time to find buyers
• Private or non-traded securities

Example: A small-cap stock that trades only a few thousand shares per day has higher liquidity risk than a large-cap stock like Apple that trades millions of shares daily. Real estate and private equity investments are inherently less liquid than publicly traded securities.

4. Regulatory Risk

Regulatory risk is the risk that changes in laws, regulations, or enforcement will negatively impact a company or industry. This can include new compliance requirements, licensing restrictions, or outright bans on certain business practices.

Examples of regulatory risk:

• Healthcare companies affected by Medicare/Medicaid policy changes
• Financial institutions affected by banking regulations
• Energy companies affected by environmental regulations
• Technology companies affected by data privacy laws

Example: A pharmaceutical company may face regulatory risk if the FDA changes its drug approval process or if new legislation affects drug pricing. A financial services firm may face higher compliance costs due to new regulatory requirements.

5. Default Risk (Credit Risk)

Default risk is the risk that a borrower will fail to make required interest or principal payments on a debt obligation. This primarily affects bondholders and other creditors.

Factors affecting default risk:

• Company's financial health and cash flow
• Industry conditions and economic environment
• Credit rating (from agencies like Moody's, S&P, Fitch)
• Collateral and seniority of the debt

Example: A corporate bond from a company with strong finances and an AAA credit rating has much lower default risk than a junk bond from a financially stressed company rated CCC. The higher yields on lower-rated bonds compensate for this additional default risk.

Summary: Types of Unsystematic Risk

Systematic vs. Unsystematic Risk Comparison

Understanding the distinction between systematic and unsystematic risk is fundamental to Modern Portfolio Theory and the CFP exam.

How Diversification Eliminates Unsystematic Risk

Diversification works because company-specific events (good and bad) tend to cancel each other out across a portfolio. When one company underperforms due to a product failure, another company may outperform due to a successful product launch.

The Diversification Effect

As the number of securities in a portfolio increases:

• Unsystematic risk decreases at a decreasing rate (diminishing returns)
• Systematic risk remains and cannot be reduced through diversification
• Total portfolio risk approaches systematic risk as unsystematic risk approaches zero

How Many Securities for Adequate Diversification?

Research indicates that holding 20-30 securities across different industries and sectors is sufficient to eliminate most unsystematic risk. Key requirements for effective diversification:

1. Sufficient number of securities - 20-30 minimum
2. Different industries/sectors - Don't hold 30 technology stocks
3. Low correlation between holdings - Securities should not move in lockstep
4. Different market capitalizations - Mix of large, mid, and small cap
5. Geographic diversification - Domestic and international exposure

The Math of Diversification

CFP Exam Tip: Adding stocks beyond 30-40 provides minimal additional diversification benefit. The key is having securities that are not highly correlated, not simply owning more securities.

Why Investors Are NOT Compensated for Unsystematic Risk

This is one of the most important concepts in Modern Portfolio Theory:

1. Unsystematic risk can be eliminated at no cost - Simply diversify
2. Rational investors will always diversify - No reason not to
3. Market prices reflect diversified investors - Prices are set by rational actors
4. No additional return for unnecessary risk - The market doesn't pay for avoidable risk

Implication: An investor holding a concentrated portfolio (e.g., all company stock) is taking risk for which they receive no additional expected return. They would have the same expected return with a diversified portfolio but significantly less total risk.

Practical Applications

For the CFP Exam

When evaluating client portfolios, consider:

• Is the portfolio adequately diversified (20-30 securities)?
• Is there excessive concentration in one company or sector?
• Are assets correlated, reducing diversification benefits?
• Is the client taking uncompensated risk?

Common Exam Scenarios

1. Employee with concentrated company stock - Taking uncompensated unsystematic risk
2. Investor holding only one sector - Not adequately diversified
3. Question asking which risks are diversifiable - Business, financial, default, regulatory
4. Question asking which risks are non-diversifiable - Market, interest rate, inflation, exchange rate