What Is Nonsystematic Risk?
Nonsystematic risk, also known as specific risk, company-specific risk, idiosyncratic risk, or firm-specific risk, refers to the uncertainty inherent in a specific asset or investment. It is the portion of investment risk that is unique to a particular company, industry, or asset, and it can be reduced or eliminated through proper diversification. This concept is fundamental to portfolio theory, which emphasizes that investors should not view individual assets in isolation but rather as components of a broader portfolio.
History and Origin
The concept of nonsystematic risk gained prominence with the advent of Modern Portfolio Theory (MPT), pioneered by Harry Markowitz in his seminal 1952 paper, "Portfolio Selection." Markowitz's work revolutionized investment management by introducing a quantitative framework for understanding the relationship between risk and expected return in a portfolio of assets. He demonstrated that the total risk of a portfolio could be reduced by combining assets whose returns were not perfectly correlated. Markowitz was awarded the Nobel Memorial Prize in Economic Sciences in 1990 for his pioneering work in the theory of financial economics, specifically for developing the theory of portfolio choice.5 His insights highlighted that while market-wide risks affect all investments, a significant portion of an individual asset's risk is unique to that asset and can be mitigated through strategic portfolio management.
Key Takeaways
- Nonsystematic risk is unique to a specific company, industry, or asset.
- It can be significantly reduced or eliminated through proper diversification.
- Examples include a company's product recall, a labor strike, or a change in management.
- It is distinct from systematic risk, which affects the entire market and cannot be diversified away.
- Understanding nonsystematic risk is crucial for effective risk management and portfolio construction.
Formula and Calculation
Nonsystematic risk, when quantified, represents the residual variance of an asset's returns that cannot be explained by market movements. In the context of the Capital Asset Pricing Model (CAPM), an asset's total risk is composed of systematic risk and nonsystematic risk.
The total variance of an asset's return ((\sigma_i^2)) can be decomposed as:
Where:
- (\sigma_i^2) = Total variance of asset i's returns
- (\beta_i2 \sigma_m2) = Systematic risk (variance explained by market movements, where (\beta_i) is the asset's beta and (\sigma_m^2) is the variance of the market's returns)
- (\sigma_{ei}^2) = Nonsystematic risk (the unexplained variance, or residual risk)
Therefore, nonsystematic risk ((\sigma_{ei}^2)) can be expressed as:
This formula shows that nonsystematic risk is the portion of an individual asset's total risk that remains after accounting for its sensitivity to market movements.
Interpreting Nonsystematic Risk
Interpreting nonsystematic risk centers on recognizing the specific dangers that an investment faces, independent of broader market conditions. A high level of nonsystematic risk for a particular stock, for instance, implies that its price is highly susceptible to company-specific events. For investors, the presence of nonsystematic risk underscores the importance of not "putting all your eggs in one basket." By combining a variety of assets that react differently to unique circumstances, investors can aim to reduce the overall standard deviation of their portfolio's returns, thereby mitigating the impact of any single adverse event. This reduction in risk without necessarily sacrificing return is a core principle behind the risk-return tradeoff in modern investing.
Hypothetical Example
Consider an investor, Sarah, who holds a portfolio consisting solely of shares in "Tech Innovators Inc." (TII), a company specializing in cutting-edge software. If TII announces that its new flagship product has a critical bug that requires a massive recall and extensive re-development, the company's stock price would likely plummet. This decline is primarily due to a nonsystematic risk event—a problem unique to TII—and would severely impact Sarah's undiversified portfolio.
Now, imagine Sarah had diversified her holdings to include shares in "Global Food Producers Co." (GFP) and "Regional Healthcare Services" (RHS), alongside TII. When the TII product bug is announced, TII's stock still falls, but GFP and RHS are largely unaffected because their operations are unrelated to software development. Sarah's overall portfolio experiences a smaller decline than if she had invested only in TII, demonstrating how asset allocation across different industries helps mitigate nonsystematic risk.
Practical Applications
Nonsystematic risk plays a pivotal role in practical investment strategies and regulatory considerations. For portfolio managers, active management often involves analyzing individual securities to assess their unique risks and potential rewards. The goal is to construct portfolios where the nonsystematic risks of individual holdings largely offset each other, leaving mainly systematic or market risk.
Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), emphasize transparent disclosure of company-specific risk factors. Publicly traded companies are required to disclose material information that could impact their business, including potential nonsystematic risks, to allow investors to make informed decisions. For4 example, a company might disclose risks related to reliance on a single supplier, potential litigation, or specific technological obsolescence. A notable real-world instance of nonsystematic risk materializing on a large scale was the Volkswagen emissions scandal that emerged in 2015. The company faced billions in fines and recalls due to the installation of "defeat devices" in its diesel vehicles, a problem specific to Volkswagen's operations, not the entire automotive market.,
#3#2 Limitations and Criticisms
While the concept of nonsystematic risk is fundamental to portfolio theory, some criticisms exist, particularly concerning the practical assumptions of Modern Portfolio Theory (MPT) from which it derives. Critics argue that MPT, and by extension the clear distinction between systematic and nonsystematic risk, relies on assumptions such as rational investor behavior and efficient markets, which may not always hold true in real-world scenarios. For1 instance, behavioral biases can lead investors to make irrational decisions that are not adequately captured by traditional risk models.
Furthermore, the effectiveness of diversification in eliminating nonsystematic risk can be challenged during extreme market events or periods of high correlation across assets. While theoretically diversifiable, in a severe downturn, even seemingly uncorrelated assets can move in the same direction, reducing the expected benefits of risk mitigation. The ease with which nonsystematic risk can be isolated and measured precisely can also be debated, as some factors influencing individual stock prices may have subtle correlations with broader market trends or be influenced by complex, unforeseen events.
Nonsystematic Risk vs. Systematic Risk
The primary distinction between nonsystematic risk and market risk, also known as systematic risk, lies in their nature and how they can be managed.
| Feature | Nonsystematic Risk | Systematic Risk |
|---|---|---|
| Nature | Company-specific, industry-specific, or asset-specific. | Market-wide, economy-wide, affects all investments. |
| Source | Product recalls, labor strikes, management changes, raw material shortages, new competition, regulatory changes impacting a single sector. | Recessions, inflation, interest rate changes, political instability, natural disasters. |
| Diversifiable? | Yes, through holding a well-diversified portfolio of unrelated assets. | No, it cannot be eliminated through diversification. |
| Measurement | Often measured as the residual variance not explained by market movements. | Measured by beta, which indicates an asset's sensitivity to market movements. |
| Impact | Affects a specific investment or a small group of investments. | Affects the entire market or a broad segment of it. |
While nonsystematic risk can be mitigated through diversification, systematic risk is inherent to investing in the market and impacts even a fully diversified portfolio. Investors are compensated for bearing systematic risk, but theoretically, they are not compensated for bearing nonsystematic risk since it can be avoided.
FAQs
Can nonsystematic risk be completely eliminated?
In theory, nonsystematic risk can be almost entirely eliminated through sufficient diversification. By combining a large number of assets from different industries and sectors, the unique, offsetting risks of individual assets tend to cancel each other out. In practice, perfect elimination is difficult due to transaction costs, limited investment options, and the possibility of unexpected correlations during market crises.
What is the primary method for reducing nonsystematic risk?
The primary method for reducing nonsystematic risk is through diversification. This involves constructing a portfolio with a variety of assets that are not highly correlated with each other, meaning they do not tend to move in the same direction at the same time. This strategy helps to cushion the portfolio against negative events affecting any single investment.
How does nonsystematic risk relate to portfolio returns?
Nonsystematic risk does not, theoretically, offer additional compensation in terms of expected return because it can be diversified away. Investors are compensated for systematic risk, which is unavoidable. Therefore, taking on more nonsystematic risk without diversifying typically only increases the overall investment risk of a portfolio without a corresponding increase in expected return.
Is nonsystematic risk more important for individual investors or institutional investors?
Nonsystematic risk is important for both individual and institutional investors. Both types of investors benefit from reducing this type of risk through diversification. Institutional investors often have larger capital and more sophisticated tools for diversification, but the principle remains the same for individual investors building a balanced portfolio.