Non-Systematic Risk (Unsystematic Risk)

While systematic risk affects the entire market, unsystematic risk (also called non-systematic, diversifiable, or company-specific risk) affects only individual companies or industries. The key difference: unsystematic risk CAN be reduced or eliminated through diversification.

What Is Unsystematic Risk?

Unsystematic risk is risk specific to a company, industry, or sector that does not affect the broader market. It results from factors unique to a particular investment.

Key Characteristics

Key Concept: Because unsystematic risk can be eliminated through diversification, investors do not receive extra return for bearing it.

Types of Unsystematic Risk

Business Risk

Business risk relates to a company operations and ability to generate revenue.

Financial Risk

Financial risk relates to how a company finances its operations.

Key Point: Companies with high debt-to-equity ratios have higher financial risk. If earnings decline, they may struggle to meet debt obligations.

Credit Risk (Default Risk)

Credit risk is the risk that a bond issuer will fail to make interest or principal payments.

Call Risk

Call risk is the risk that a bond will be redeemed before maturity, usually when interest rates fall.

• Issuer calls bonds to refinance at lower rates
• Investor must reinvest at lower current rates
• Affects callable bonds and preferred stock

Liquidity Risk

Liquidity risk is the risk that an investment cannot be quickly sold at fair value.

Legislative/Regulatory Risk

Legislative risk is the risk that new laws or regulations will negatively impact an investment.

• Changes in tax laws
• Industry-specific regulations
• Environmental requirements
• Trade restrictions

Event Risk

Event risk is the risk from unexpected events affecting a specific company.

• Mergers and acquisitions
• Natural disasters damaging facilities
• Lawsuits and legal judgments
• Management fraud or scandals

Reducing Unsystematic Risk: Diversification

Diversification is the primary tool for reducing unsystematic risk.

How Diversification Works

By spreading investments across many securities, the impact of any single company problems is reduced.

Diversification Methods

Systematic vs. Unsystematic Risk Comparison

Total Risk

Total risk is the combination of systematic and unsystematic risk:

Total Risk = Systematic Risk + Unsystematic Risk

• Measured by standard deviation
• A diversified portfolio has mostly systematic risk remaining
• An undiversified portfolio has both types

Practical Application

For Individual Stock Investors

• Diversify across at least 20-30 stocks
• Spread across different sectors
• Consider international exposure
• No single position should dominate

For Fund Investors

Mutual funds and ETFs provide instant diversification:

• S&P 500 index fund = 500 large-cap stocks
• Total stock market fund = thousands of stocks
• One fund can eliminate most unsystematic risk

Key Takeaways

• Unsystematic risk is company-specific and diversifiable
• Main types: business, financial, credit, call, liquidity, regulatory
• Diversification reduces unsystematic risk
• 20-30 stocks can eliminate most unsystematic risk
• Investors are NOT compensated for unsystematic risk
• After diversification, only systematic risk remains