3.2 Unsystematic (Company-Specific) Risk

Unsystematic risk (also called diversifiable risk, specific risk, unique risk, or idiosyncratic risk) is risk that affects a particular company, industry, or sector. Unlike systematic risk, unsystematic risk can be reduced or eliminated through proper diversification.

The Key Distinction

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Types of Unsystematic Risk

1. Business Risk

Business risk is the risk associated with a company's operations, management, and competitive position.

Example: A pharmaceutical company's drug fails clinical trials—this affects only that company, not the entire market.

2. Financial Risk

Financial risk is the risk arising from a company's use of debt (leverage) in its capital structure.

Key Point: Financial risk increases with leverage because:

• Interest must be paid regardless of profits
• Debt covenants restrict flexibility
• High debt increases bankruptcy probability
• Earnings become more volatile

Measured by: Debt-to-equity ratio, interest coverage ratio

3. Credit Risk (Default Risk)

Credit risk is the risk that a borrower fails to make required payments on debt obligations.

Credit Rating Agencies: Moody's, S&P, Fitch

4. Liquidity Risk

Liquidity risk is the risk of not being able to sell an investment quickly at a fair price.

Liquidity Spectrum:

5. Legislative/Regulatory Risk

Legislative risk is the risk that laws or regulations will negatively affect a specific company or industry.

6. Concentration Risk

Concentration risk is the risk from lack of diversification—having too much exposure to a single investment.

Examples of Concentration Risk:

• Employee with 80% of portfolio in company stock
• Investor holding only technology stocks
• Retirement savings entirely in one mutual fund

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The Power of Diversification

Diversification is the primary tool for reducing unsystematic risk:

Research Finding: Approximately 20-30 uncorrelated stocks can eliminate most unsystematic risk. Beyond that, additional diversification provides diminishing benefits.

Types of Diversification

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In Practice: How Investment Advisers Apply This

Portfolio construction:

• Ensure adequate diversification (20+ securities minimum)
• Diversify across industries and sectors
• Consider correlation between holdings
• Watch for concentration in client-held assets (company stock)

Client education:

• Explain that diversification eliminates company-specific risk
• Help clients understand they shouldn't panic over single-company news
• Discuss the dangers of concentrated positions (employer stock)

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On the Exam

The Series 65 exam tests your understanding of:

1. Definition of unsystematic risk and that it CAN be diversified away
2. Types: Business, financial, credit, liquidity, legislative, concentration
3. Relationship between diversification and unsystematic risk reduction
4. How many stocks are needed to diversify (20-30)
5. Credit ratings and what they measure

Common formats include identifying which risks are diversifiable and understanding credit risk.

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Key Takeaways

• Unsystematic risk affects specific companies and CAN be diversified away
• Business risk relates to company operations and management
• Financial risk increases with leverage (debt)
• Credit/default risk is the risk of non-payment on debt
• Liquidity risk is the difficulty of selling quickly at fair price
• 20-30 uncorrelated stocks eliminate most unsystematic risk
• Diversification reduces unsystematic risk but NOT systematic risk
• Credit ratings (S&P, Moody's) measure default risk