Company specific risk: Meaning, Criticisms & Real-World Uses

What Is Company Specific Risk?

Company specific risk, also known as unsystematic risk or diversifiable risk, is the uncertainty inherent in a particular investment arising from factors unique to a specific company or industry. This type of risk falls under the broader category of Risk management within Portfolio theory, differentiating it from risks that affect the entire market. Unlike broader market movements, company specific risk can stem from internal operational issues, management decisions, product recalls, labor disputes, or even changes in a company's Capital structure. It is a significant consideration for investors aiming to construct a resilient Investment portfolio through strategic Diversification.

History and Origin

The concept of distinguishing between diversifiable and non-diversifiable risks gained prominence with the development of modern portfolio theory in the mid-20th century. While investors intuitively understood that putting "all their eggs in one basket" was risky, academic frameworks, notably Harry Markowitz's seminal work on portfolio selection, formalized how different types of risk behave and how they can be managed. This theoretical foundation highlighted that certain risks, such as company specific risk, could be mitigated through appropriate portfolio construction, while others, known as Systematic risk, could not. As financial markets evolved and became more interconnected, the understanding and quantification of these distinct risk types became critical for both individual investors and institutional managers. For instance, regulatory changes in the banking sector in the United States, particularly from the 1980s through the mid-1990s, facilitated the expansion of banks across state lines. This increased geographic reach allowed banks to better diversify their loan portfolios and revenue streams, thereby reducing their exposure to localized Economic downturn and specific regional economic shocks. This historical shift underscores the practical application of managing company specific risk at an institutional level.⁵, ⁶

Key Takeaways

Company specific risk is unique to a single company or industry and is not correlated with broader market movements.
It encompasses factors such as management changes, product failures, labor issues, and company-specific Financial risk or Operational risk.
Unlike systematic risk, company specific risk can be reduced or largely eliminated through adequate Diversification within an investment portfolio.
Understanding and managing company specific risk is fundamental to achieving a desired Expected return for a given level of risk.

Formula and Calculation

Company specific risk, while not directly calculated by a single formula, is implicitly captured in measures of asset volatility beyond what can be explained by market movements. In the Capital Asset Pricing Model (CAPM), total risk is decomposed into systematic risk (measured by Beta) and unsystematic (company specific) risk. The total variance of an asset's returns can be expressed as:

\sigma^2_{total} = \beta^2 \sigma^2_{market} + \sigma^2_{unsystematic}

Where:

(\sigma^2_{total}) represents the total variance of the individual asset's returns.
(\beta) is the asset's beta, measuring its sensitivity to market movements.
(\sigma^2_{market}) is the variance of the market's returns.
(\sigma^2_{unsystematic}) is the variance attributed to company specific (unsystematic) risk.

The (\sigma^2_{unsystematic}) component represents the portion of the asset's total risk that can be diversified away. It signifies the volatility that stems from factors unique to the company itself, independent of the overall market.

Interpreting the Company Specific Risk

The significance of company specific risk for an investor largely depends on their degree of Diversification. For an investor holding only one or a few individual Equity securities, company specific risk is a paramount concern, as a negative event impacting that particular company could severely diminish their investment. For example, if a company announces a significant product recall, its stock price could plummet, directly impacting a concentrated portfolio.

Conversely, in a highly diversified portfolio with numerous assets across various industries and sectors, the impact of a negative event affecting a single company is considerably lessened. The losses from one company might be offset by gains or stability in others. Therefore, interpreting company specific risk involves assessing the potential impact of unique company events on the overall portfolio, with greater exposure in less diversified portfolios and minimal impact in well-diversified ones. The primary goal of portfolio construction is to reduce this type of risk to a negligible level.

Hypothetical Example

Consider an investor, Alex, who has $10,000 to invest.

Scenario A: Concentrated Portfolio
Alex decides to invest all $10,000 in shares of a single technology company, "TechInnovate Inc." (TII), believing it has a revolutionary new product. This portfolio has very high company specific risk.

Step 1: Investment: Alex buys 100 shares of TII at $100 per share.
Step 2: Unforeseen Event: Two months later, TII announces that its highly anticipated product has a critical design flaw and its release will be delayed indefinitely. This is a company specific event.
Step 3: Impact: Due to the news, TII's stock price drops by 50% to $50 per share.
Result: Alex's investment is now worth $5,000, representing a $5,000 loss, solely due to an event unique to TII.

Scenario B: Diversified Portfolio
Instead, Alex decides to diversify their $10,000 by investing in ten different companies across various sectors, allocating $1,000 to each. One of these companies is TII. This portfolio has much lower company specific risk.

Step 1: Investment: Alex buys 10 shares of TII at $100 per share ($1,000 total) and $1,000 in each of nine other unrelated companies.
Step 2: Unforeseen Event: TII announces its product delay, and its stock price drops by 50% to $50 per share.
Step 3: Impact: The $1,000 investment in TII is now worth $500, a $500 loss. However, the other nine companies in the portfolio are unaffected by TII's news, maintaining their value.
Result: Alex's total portfolio value becomes $9,000 (9 companies * $1,000 + $500 from TII), representing a $500 loss. While TII's company specific risk materialized, the impact on Alex's overall Investment portfolio was significantly reduced due to Asset allocation across multiple holdings.

Practical Applications

Company specific risk is a critical consideration across various financial disciplines. In Investment portfolio management, it is primarily addressed through Diversification. Investors build portfolios that include a variety of asset classes, industries, and geographic regions to minimize the impact of adverse events affecting a single entity. For example, an investor might hold shares in technology companies, healthcare providers, and consumer staples businesses to reduce the overall company specific risk of their stock holdings. The Securities and Exchange Commission (SEC) actively educates investors on the importance of this strategy, emphasizing that diversification can help manage the risk that any single investment will yield a subpar return.³, ⁴

In corporate finance, companies themselves engage in Risk management to identify and mitigate their own company specific risks, such as supply chain disruptions, product liability, or unfavorable regulatory changes. An example of significant company specific risk materializing occurred with Wells Fargo, which faced multiple penalties and widespread public scrutiny stemming from practices between 2002 and 2016 where employees opened millions of unauthorized accounts. The Department of Justice reported that Wells Fargo agreed to pay $3 billion to resolve criminal and civil investigations into these sales practices.² Such incidents highlight how internal corporate governance failures and unethical sales practices, which are company-specific factors, can lead to substantial financial penalties, reputational damage, and a significant impact on the company's stock price and long-term viability.

Limitations and Criticisms

While diversification is highly effective at reducing company specific risk, it is not without limitations. A primary critique is that diversification cannot eliminate Systematic risk, which is the risk inherent to the entire market or economic system. Events such as a global Financial crisis, widespread inflation, or a significant change in interest rates will typically affect all investments, regardless of how well-diversified a portfolio is in terms of company specific factors. For instance, the 2008 financial crisis demonstrated how a systemic event, originating in the U.S. housing market, spread globally and impacted nearly all financial institutions and economies, irrespective of their individual company health.¹ During such periods, even a highly diversified portfolio may experience losses.

Furthermore, over-diversification can sometimes lead to "diworsification," where adding too many assets dilutes potential returns from strong performers without significantly reducing overall risk beyond a certain point. It can also increase transaction costs and make a portfolio more cumbersome to manage. Another limitation is that truly unique, high-growth opportunities within a single company, which might offer extraordinary returns, may be diluted in a broadly diversified portfolio. Investors seeking such concentrated gains consciously accept higher company specific risk. Finally, effective Regulatory risk management and compliance are crucial; a failure in these areas can expose a company to severe penalties that diversification alone cannot offset, as seen in cases of corporate misconduct.

Company specific risk vs. Market risk

The key distinction between company specific risk and Market risk lies in their origin and diversifiability.

Feature	Company Specific Risk (Unsystematic Risk)	Market Risk (Systematic Risk)
Origin	Unique to a specific company or industry (e.g., management, product, operations, litigation).	Affects the entire market or economy (e.g., recessions, inflation, interest rate changes, geopolitical events).
Diversifiability	Can be significantly reduced or eliminated through Diversification by holding a broad portfolio of assets.	Cannot be eliminated through diversification; it is inherent to investing in the overall market.
Impact	Affects the value of individual securities or a small group of related assets.	Influences the returns of nearly all assets in the market.

Confusion often arises because both types of risk contribute to the total risk of an investment. However, investors primarily focus on managing company specific risk through diversification, as it is the component of total risk that they have the most control over. Market risk, on the other hand, is a non-diversifiable risk that all participants in a given market must bear.

FAQs

What is the primary difference between company specific risk and systematic risk?

The primary difference is that company specific risk, also known as Unsystematic risk, is unique to a particular company or industry and can be reduced through Diversification. Systematic risk, or market risk, affects the entire market and cannot be eliminated through diversification.

Can company specific risk be completely eliminated?

While company specific risk can be significantly reduced through robust Diversification across many different investments, it is practically impossible to eliminate it entirely. There will always be some residual risk associated with individual assets, even in a highly diversified portfolio.

Why is it important for investors to understand company specific risk?

Understanding company specific risk is crucial because it helps investors make informed decisions about how to construct their Investment portfolio to achieve their desired risk-return profile. By diversifying, investors can protect their capital from unforeseen negative events affecting a single company or sector.