There are several concepts revolving around unsystematic risk management. This article is your go-to guide that explains all that you need to know about unsystematic risk, in a very comprehensive manner.
What is An Unsystematic Risk?
Just like the question, the answer also is simple since the unsystematic risk is associated with the internal risk factors of the firm. Unsystematic risk is also known as specific risk, diversifiable risk, idiosyncratic risk or residual risk. An unsystematic risk arises from any such event the business is not prepared for and which disrupts the normal functioning of the business.
For instance, a firm may generate high profits in case of which the stock prices go up. On the other hand, some other firm may generate low profits which make its stock prices go down.
Some of the factors leading to unsystematic risk include:
- The inefficiency of the management
- Flaws in the business model
- Liquidity crunch in the business
- Changes in the capital structure
- Production of non-desirable products
- Labour strikes
Unsystematic risk is diversifiable in nature and thus, can be avoided. It is a fact that you can diversify your portfolio by buying shares of different companies and also in different geographical locations. This way, even if some businesses that you have invested in face adversity because of unsystematic risk, not all businesses will. Hence, the unsystematic risk which is unique to one or a couple of stocks gets avoided.
Below, you can see the graph explaining unsystematic risk.
Source: CFI
In the graph, we have taken total portfolio risk on y-axis and number of stocks on x-axis.
It is clearly visible in the graph that an unsystematic risk is more in case you do not have a diversified portfolio. But, as you start investing in more than one stocks, your unsystematic risk goes down and approaches zero.
Nevertheless, systematic risk depends on various macroeconomic factors such as interest rate hike and inflation which can not be avoided.
Recently, we can take the outbreak of the coronavirus pandemic as an example. It affected the entire financial ecosystem and the financial markets suffered great losses.
We will discuss the definition of unsystematic risk now to make it clear in brief what this type of risk implies.
In the next installment, the author will look at an example.
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