Unsystematic risk

What Is Unsystematic Risk?

Unsystematic risk, also known as idiosyncratic risk or specific risk, is the uncertainty inherent in a single asset or a specific company or industry. This type of financial risk arises from factors unique to a particular investment, rather than broader market movements. Within the realm of portfolio theory, unsystematic risk stands in contrast to market-wide risks because it can typically be mitigated or eliminated through diversification. It encompasses events and conditions that affect a specific entity or a small group of entities, such as a company's management decisions, product recalls, labor strikes, or changes in industry regulations. Unsystematic risk is a key consideration for investors aiming to construct a well-balanced portfolio.

History and Origin

The concept of distinguishing between diversifiable and non-diversifiable risks gained prominence with the development of Modern Portfolio Theory (MPT). Pioneered by economist Harry Markowitz, MPT was introduced in his seminal 1952 paper, "Portfolio Selection," published in The Journal of Finance.¹⁴ Markowitz's work fundamentally changed how investors approached investment by providing a mathematical framework for constructing an optimal portfolio that maximizes expected return for a given level of risk.¹³ He demonstrated that combining assets whose returns are not perfectly correlated can reduce the overall risk management of a portfolio without sacrificing expected returns, a concept he famously referred to as "the only free lunch in finance."¹² This groundbreaking insight, for which Markowitz shared the Nobel Memorial Prize in Economic Sciences in 1990, laid the foundation for understanding and quantifying unsystematic risk as the component of total risk that can be eliminated through broad portfolio diversification.¹⁰, ¹¹

Key Takeaways

Unsystematic risk is specific to a particular company, industry, or asset and is not related to broader market movements.
Examples include product recalls, labor disputes, changes in company management, or new regulatory impacts on a specific sector.
This type of risk can be significantly reduced or nearly eliminated through diversification across different assets, industries, and geographic regions.
It is a key component of total investment risk, alongside systematic risk, which cannot be diversified away.
Understanding unsystematic risk is crucial for effective asset allocation and risk management in portfolio construction.

Formula and Calculation

While there isn't a direct standalone formula to calculate unsystematic risk in isolation, it is understood as the portion of an asset's or portfolio's total risk that remains after accounting for market-wide movements. The relationship between total risk, systematic risk, and unsystematic risk is expressed as:

\sigma_{total}^2 = \sigma_{systematic}^2 + \sigma_{unsystematic}^2

Where:

(\sigma_{total}^2) = Total variance of the asset's or portfolio's returns (a measure of total risk).
(\sigma_{systematic}^2) = Variance due to market movements (systematic risk, often measured using beta).
(\sigma_{unsystematic}^2) = Variance due to company-specific factors (unsystematic risk, also known as idiosyncratic risk).

From this, unsystematic risk squared (variance) can be derived:

\sigma_{unsystematic}^2 = \sigma_{total}^2 - \sigma_{systematic}^2

In practical application, the total risk is measured by the standard deviation of an asset's returns. Systematic risk is typically quantified using beta from models like the Capital Asset Pricing Model (CAPM), which explains the expected return of an asset based on its sensitivity to market movements.⁹ The remaining unexplained portion of the variance is attributed to unsystematic risk.

Interpreting Unsystematic Risk

Interpreting unsystematic risk primarily revolves around its diversifiability. A high degree of unsystematic risk for a particular investment indicates that its price movements are heavily influenced by internal, company-specific or industry-specific events, rather than general market trends. For a well-diversified portfolio, this component of risk is largely irrelevant because the negative impact of an adverse event affecting one asset is typically offset by the performance of other unrelated assets within the portfolio.

Conversely, a portfolio heavily concentrated in a few assets or a single industry will have a high exposure to unsystematic risk. In such cases, internal developments within those specific holdings can lead to significant swings in the portfolio's overall value. Investors should aim to reduce their exposure to unsystematic risk through prudent diversification across various asset classes, industries, and geographies.

Hypothetical Example

Consider an investor, Alex, who holds a highly concentrated portfolio consisting solely of shares in "Tech Innovations Inc.," a hypothetical software company.

One morning, news breaks that Tech Innovations Inc.'s flagship product has a major security flaw, leading to a significant data breach. The company's stock plummets by 30% in a single day as investors react to the news. This sharp decline in value is an example of unsystematic risk manifesting. The broader stock market, represented by a major index, might experience a small fluctuation or even rise on the same day, indicating that the decline in Tech Innovations Inc.'s stock was specific to the company itself, rather than a market-wide downturn.

If Alex had instead diversified their investment across various companies in different sectors—e.g., Tech Innovations Inc., a utility company, and a consumer goods manufacturer—the impact of the 30% drop in Tech Innovations Inc. would be softened. The other holdings would likely be unaffected or even perform positively, buffering the overall portfolio's decline. This illustrates how portfolio diversification reduces exposure to company-specific or idiosyncratic risk.

Practical Applications

Unsystematic risk appears in several practical aspects of investment and risk management:

Portfolio Construction: The primary application is in designing diversified portfolios. By combining assets with low or negative correlation, investors can minimize the overall impact of specific company or industry events. This means holding a mix of stocks from different sectors, bonds, and other asset classes.
Regulatory Requirements: Regulatory bodies often impose diversification requirements on certain investment vehicles, such as mutual funds, to protect investors from excessive unsystematic risk. For example, under the Investment Company Act of 1940, a "diversified company" must adhere to specific rules, often referred to as the "75-5-10 rule," limiting the concentration of assets in any single issuer. Thi⁷, ⁸s regulation aims to ensure that funds marketed as "diversified" truly offer a spread of risk.
⁶ Active vs. Passive Management: Investors in actively managed funds often pay higher fees in the hope that managers can generate alpha by making specific stock selections that outperform the market. However, a significant portion of the active manager's skill lies in mitigating company-specific risk through intelligent asset allocation and stock picking, thereby enhancing risk-adjusted returns.
Event-Driven Investing: Certain investment strategies, such as event-driven investing, actively seek to profit from company-specific events like mergers, acquisitions, or bankruptcies. These strategies directly engage with unsystematic risk, betting on the outcome of specific corporate actions. A notable real-world example of company-specific events impacting a stock occurred with Boeing's 737 MAX aircraft. Following two fatal crashes, the company experienced a significant drop in its stock value due to safety concerns and subsequent groundings, demonstrating how specific issues can affect a company's market performance independent of broader market trends.

##³, ⁴, ⁵ Limitations and Criticisms

While the ability to diversify away unsystematic risk is a cornerstone of Modern Portfolio Theory, several limitations and criticisms exist.

One criticism is that complete diversification, which would fully eliminate unsystematic risk, is difficult to achieve in practice due to transaction costs, limited investment capital, and the availability of truly uncorrelated assets. Investors with smaller portfolios might find it challenging to hold enough different securities to fully negate specific risks.

Fu²rthermore, the effectiveness of diversification in periods of extreme market stress has been questioned. During financial crises, correlations between asset classes tend to increase, meaning that even seemingly unrelated assets may move in the same direction. This phenomenon, often referred to as "correlation breakdown," can reduce the protective benefits of diversification precisely when investors need them most. Critics suggest that Modern Portfolio Theory, which forms the theoretical basis for diversifying unsystematic risk, relies on assumptions about asset return distributions and investor rationality that may not always hold true in real-world markets. The¹ Bogleheads Wiki, for instance, points out various limitations of MPT, including its reliance on historical data which may not predict future performance, and its assumption of efficient markets.

Lastly, some argue that an overemphasis on diversifying away unsystematic risk can lead to overly conservative portfolios that miss out on significant gains from strong-performing individual companies. Active managers, for example, often seek to capitalize on unique company-specific risk factors to generate alpha, rather than just minimizing it.

Unsystematic Risk vs. Systematic Risk

The distinction between unsystematic risk and systematic risk is fundamental in portfolio theory.

Unsystematic risk, also known as diversifiable risk or idiosyncratic risk, is specific to a particular company, industry, or asset. It arises from factors unique to that entity, such as management changes, product innovation or failure, labor strikes, regulatory approvals, or specific legal challenges. Because these events affect only a subset of the market, their impact on a portfolio can be largely mitigated through diversification—by combining a variety of different assets across various industries and sectors, the unique risks of individual holdings tend to cancel each other out.

In contrast, systematic risk, also known as non-diversifiable risk or market risk, refers to the inherent risks that affect the entire market or a broad segment of it. These risks stem from macroeconomic factors like inflation, interest rate changes, political instability, recessions, or major geopolitical events. Systematic risk cannot be eliminated through diversification because all investments are, to some degree, exposed to these pervasive market forces. Investors are compensated for bearing systematic risk through higher expected returns, as measured by concepts like beta.

FAQs

What is the primary difference between unsystematic risk and market risk?

The primary difference is that unsystematic risk (also called company-specific risk or idiosyncratic risk) is specific to an individual asset or company and can be reduced through diversification, while market risk (systematic risk) affects the entire market and cannot be eliminated through diversification.

Can unsystematic risk be completely eliminated?

While unsystematic risk can be significantly reduced through effective portfolio diversification, it is practically impossible to eliminate it entirely. Even with a highly diversified portfolio, some minimal exposure to specific risks may remain, and in extreme market conditions, the benefits of diversification can diminish.

Why is diversification important for managing unsystematic risk?

Diversification is important for managing unsystematic risk because it spreads your investment across various assets, industries, and geographies. If one specific asset or sector performs poorly due to a unique event, the negative impact on the overall portfolio is minimized as other assets might perform well or remain unaffected, thus smoothing out returns.