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What Is an Unsystematic Risk?

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  • Written By: James Corey
  • Edited By: C. Wilborn
  • Last Modified Date: 27 July 2014
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Unsystematic risk is a concept in finance and portfolio theory that refers to the extent to which a company's stock return is uncorrelated with the return of the overall stock market. This type of risk may be thought of as industry-specific or company-specific risk. It is the opposite of systematic risk, which is that risk inherent to an entire market.

It is commonly referred to as specific or idiosyncratic risk, since unsystematic risk affects only a relatively few firms rather than the overall market. For example, the risk of food poisoning is unsystematic risk, since it applies only to firms handling human food. Key man risk is also unsystematic, since few individual companies are likely to suffer a large drop in value if their leaders were to suffer unexpected incapacitation.

The unsystematic risk inherent in individual stocks is routinely quantified by professional investors using statistical regression analysis. Like all forms of risk, it is measured as the volatility of returns, with returns including both stock, or share, price appreciation and dividends.

From the point of view of an investor, all risk is a negative. Some risk is less negative than others, however, and detracts less from the value of an asset. Unsystematic risk is preferable to systematic risk since its negative effect can be removed within the context of an overall portfolio. As a result, unsystematic risk is also known as diversifiable risk.

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The concept of unsystematic and systematic risk is very helpful for investors seeking to construct a large, diversified investment portfolio that mirrors the overall market. If constructed well, that portfolio will closely track the market. If the market increases in value, the portfolio will also increase in value by the same percentage. If the overall market decreases in value, the portfolio will also go down.

Adding a stock that is uncorrelated with the overall market to a portfolio will tend to decrease the volatility of that portfolio's return. To that extent, the portfolio is said to become more efficient. The unsystematic risk of the individual stock is removed through the diversification inherent in the overall portfolio.

The investment market does not reward investors for carrying unsystematic risk — it does not allow investors to be compensated for incurring the specific risk inherent in an individual stock. Competition in the investment market drives down the price of a stock to a level that eliminates any compensation for this risk. Efficient investors neutralize the negative impact of unsystematic risk through efficient portfolio diversification.

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Discuss this Article

anon332914
Post 3

Theoretically saying, it appears fine but the market in reality doesn't behave the way it is assumed. CAPM is in a dire situation, is taking its last breath and sincerely requires a thorough revisit and suitable adjustment in model to sustain.

JaneAir
Post 2

@starrynight - I think that's a pretty good example of an unsystematic risk. I also think what the article said about paying attention to such things when you invest makes a lot of sense.

Everyone is always saying how important it is to diversify your portfolio, but it really is so true. That way if one of your stocks goes down because of an unsystematic risk your other investments won't be affected.

starrynight
Post 1

This is very interesting. I've never given much thought to all the factors that affect a stocks performance, but this totally makes sense.

For example, I would imagine a stock could be affected if an iconic company leader stepped down. Some companies don't have very visible leadership, so they wouldn't be affected by this. But for a company whose leader is closely associated with performance, it could affect the stock price.

But this would be unsystematic for sure, because other companies in the same sector wouldn't be affected by this.

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