What is Unsystematic Risk?
Unsystematic risk is a risk that is inherent and specific to a company or industry. As we know, each and every business has some amount of risk. In the world of business finance, such risks are of two types – systematic and unsystematic. In other words, unsystematic risk affects a company or only one industry. An investor in such a company or industry can avoid or minimize such risks by diversifying his portfolio across multiple industries. Hence, such risks are also known as non-systematic or diversifiable risks.
Such risks arise primarily due to internal factors. Thus, it is possible to avoid and control these risks. A few examples of such risks are changes in the rules and regulations for a particular industry, the entry of a new rival into the industry, recalling a product, a union strike, and much more.
- What is Unsystematic Risk?
- Types of Unsystematic Risk
- Unsystematic Risk – Advantages and Disadvantages
- How to Measure Unsystematic Risk
- Final Words
- Frequently Asked Questions (FAQs)
Incidentally, there is no mathematical formula to estimate such type of risk. However, there is a roundabout way to calculate this. This way, it is derived from deducting systemic risk from the overall risk. Or, we can use beta to measure this risk.
At the time of investing, an investor may be aware of some of the risks a company may face. But, it is almost impossible for investors to know all the future risks that a company may be exposed to. Therefore, it is very important for an investor to diversify their portfolio across industries and firms to reduce their risk.
Example of Unsystematic Risk
Suppose, for example, the transport operators call for a strike. And, if you hold shares in the transport industry, your investments will get a direct hit due to the effects of this unsystematic risk. However, if your investments are not concentrated in the transport industry alone. Instead, if it is well-diversified across other industries/firms, then the impact of the strike on the overall portfolio investments will be very less or minimal. Of course, the extent of the impact will depend upon the quantum of investments in this industry vis-a-vis the overall investments. In such a case, you can add airline stock or railway stock to diversify your portfolio.
Types of Unsystematic Risk
The following are the types of unsystematic risks:
These include any internal factors that may risk the revenue and performance of a company. This could be not obtaining proper copyright for a new brand name or a patent for the new product. Thereby the competitor can have a freehand to introduce the same product or use the same brand name. The business risk can be due to external factors also, such as government agencies that may prohibit a drug that a company sells.
Financial risk relates to a company’s capital structure. As we know, the capital structure of all the companies usually has a mix of debt and equity. Moreover, to derive maximum benefits from the capital structure, a company must maintain and strive to achieve an optimal mix of debt and equity. But, if a company fails to maintain a balance between the two, it could affect cash flows and earnings. Therefore, the risk arises from the sub-optimal level of the debt-equity mix.
Such risks arise due to negligence or unforeseen events, such as supply chain problems, breakdown of machinery, data breaches, etc. We can say that operational risks include risks from day-to-day operations. Normally companies take up preventive maintenance exercises regularly to avoid equipment-related issues.
This risk involves management’s failure to make the right strategic decisions regarding its product or services. An example of this is the company entering into a partnership with a fraud entity or the entity that is not so interested in the activities of the company. Another example could be the management could not visualize in advance or not being able to change course when a product is not performing well.
Legal and Regulatory Risk
As the name implies, these legal risks relate to changes in laws or regulations that go against a company or industry. Usually, such changes increase costs or make operations more difficult. These risks also include companies violating laws or breaking agreements.
Unsystematic Risk – Advantages and Disadvantages
Following are the advantages of Unsystematic risk:
- This risk relates only to a particular company or industry and does not affect the overall economy.
- Such risks can easily be avoided or reduced by diversifying their portfolios.
- The factors that lead to risks are internal. Therefore, appropriate internal monitoring and measures can help avoid or minimize such risks.
- The severity of the unsystematic risk is usually lower than the systematic risk. The duration of the impact is also lower than the systematic risk.
- Because unsystematic risk is limited to one company or industry, the number of people affected is smaller. Also, the money at stake is usually less than systematic risk.
Following are the disadvantages of Unsystematic risk:
- Such a risk can have an impact on the specific industry and cause disruption, even when the economy is doing well.
- Although the risk is specific to a company or industry, it can take some time for things to return to normal. And, if any other issue arises in between, the duration could be even longer.
- At some point, unsystematic risk can lead to a permanent change in the preference of the customers. And if that happens, such risks could have serious repercussions on the market of such a company or industry.
- Unsystematic risks are usually not repetitive. This makes it difficult for management to plan as they will face a new problem the next time, and previous preparations are useless.
- Such risks can have a severe impact on workers’ and employees’ confidence, and they start to feel job insecurity.
- Sometimes a company needs to spend a massive amount of time and resources to overcome or manage such risks.
- Since it does not affect the economy or affect fewer people, state intervention is rare. So, it is up to private executives to resolve the matter themselves. Moreover, there is little or no financial compensation or help from the government.
- Although this risk does not affect the economy, it does bring a degree of negativity to the economy.
- Though it may affect one firm or industry, it may also have an adverse impact on the other firms and industries. Particularly, those have some sort of interdependency with such a firm or industry. For example, falling out of any firm or industry segment may affect the banking industry.
How to Measure Unsystematic Risk
The Beta coefficient of a company is what represents the unsystematic risk. A beta coefficient is the relationship of the change of a stock with a change in the market. In other words, it indicates the extent of the volatility of a stock/security vis-a-vis the market. Nowadays, the beta coefficient of each stock can be obtained online. A stock with a lesser beta is less volatile and vice versa.
For example, the beta coefficients of two stocks, A and B, are 1.15 and 1.02, respectively. Since stock B has a lower coefficient, this means it is less volatile. Therefore, the rate of change will be lower for B as compared to A. Therefore, stock B is more apt for investment.
Calculation of Portfolio Beta
Similarly, one can calculate the total beta of a portfolio. Suppose a portfolio consists of two stocks. The formula for total beta =
(% investment in Stock 1 * Beta of Stock 1) + (% investment in Stock 2 * Beta of Stock 2)
Now let us assume that in the example of Stock A and B above, an investor has 60% in A and 40% in B.
Total Beta of Portfolio = (60% * 1.15) + (40% * 1.02) = 0.69 + 0.408 = 1.098.
Let’s see how diversification works. Suppose the total return of the portfolio was 15%. But the individual return on stock A and B was 1% and 16%, respectively. This means that if an investor had invested only in A, the return would have been only 1%. But, because the investor diversified, the return was higher. Of course, it is lesser than the return of B (16%) if he had been fully invested in B.
The unsystematic risk is dynamic because of the problems that each company or sector faces are unique. It has no correlation with the overall economy, and the scale of the impact is also lower. Therefore, the government usually does not intervene, and private players only need to address the issue at hand. Hence, an investor should opt for portfolio diversification to avoid deep shocks.
Frequently Asked Questions (FAQs)
A. Market risk
B. Systematic risk
C. Unsystematic risk
C. Unsystematic risk
Yes. If the investor’s portfolio is not diversified and he owns very limited stocks, the unsystematic risk can be negative.
Types of unsystematic risk are::
a) Business risk
b) Financial risk
c) Operational risk
d) Strategic risk
e) Legal & regulatory risk
a) It is limited to a particular company or industry.
b) Can be avoided by diversifying the portfolio.