Unsystematic risk is the risk that is specific to a particular company, industry, or asset. It is distinct from systematic risk, which affects the entire market or a broad segment of it. Unsystematic risk can be attributed to factors and events that are unique to a specific investment, and it can often be reduced or eliminated through diversification.
Key Characteristics of Unsystematic Risk
Company-Specific Events: Unsystematic risk arises from events and circumstances that are specific to a particular company. These can include management changes, product recalls, litigation, or disruptions in the supply chain.
Diversifiable: Unlike systematic risk, which cannot be eliminated through diversification, unsystematic risk can be mitigated by holding a diversified portfolio of assets. When an investor holds a wide range of investments, the impact of unsystematic risk is spread out.
Non-Market Factors: Unsystematic risk is not related to overall market movements, economic trends, or geopolitical events. Instead, it is tied to the unique characteristics and operations of individual companies.
Reducible: Through proper portfolio management and diversification, investors can reduce or eliminate unsystematic risk. This risk can be diversified away by holding a portfolio of assets with low correlations to one another.
Sources of Unsystematic Risk
Unsystematic risk can emanate from various sources, and understanding these sources is crucial for managing and mitigating this type of risk effectively:
Business Risk: This risk arises from factors specific to a company’s operations, such as changes in market demand, competition, or technological advancements that can impact the company’s profitability.
Financial Risk: Financial risk is associated with a company’s capital structure and financial decisions. It includes risks related to debt levels, credit ratings, and financial stability.
Management Risk: The competence and decision-making of a company’s management team can contribute to unsystematic risk. Poor leadership or mismanagement can lead to adverse outcomes.
Regulatory and Legal Risk: Companies are subject to various regulations and legal requirements that can affect their operations and financial performance. Legal disputes, regulatory changes, and compliance issues can all contribute to unsystematic risk.
Operational Risk: This type of risk stems from a company’s day-to-day activities. It includes risks related to supply chain disruptions, manufacturing issues, and operational inefficiencies.
Reputation Risk: Negative publicity, scandals, or public perception issues can damage a company’s reputation and impact its financial health.
Measurement of Unsystematic Risk
Measuring unsystematic risk can be challenging, but there are several methods and metrics that investors and analysts use to assess and quantify this type of risk:
Beta: Beta measures an asset’s sensitivity to overall market movements (systematic risk). Assets with a beta close to 1 are considered to have average systematic risk, while those with betas significantly different from 1 may have higher or lower systematic risk. Unsystematic risk can be inferred by analyzing the difference between an asset’s actual returns and its expected returns based on beta.
Standard Deviation: Standard deviation quantifies the volatility of an asset’s returns. Assets with higher standard deviations are considered riskier, as they exhibit more significant price fluctuations. Part of the standard deviation is attributed to unsystematic risk.
Residual Risk: Residual risk, also known as idiosyncratic risk, is the risk that remains after accounting for systematic risk factors. It is typically estimated using statistical models, such as regression analysis.
Tracking Error: Tracking error is commonly used in the context of mutual funds or exchange-traded funds (ETFs) and measures how closely a fund’s returns align with those of its benchmark index. Tracking error is a useful indicator of unsystematic risk within a fund’s portfolio.
Managing and Mitigating Unsystematic Risk
Investors have several strategies at their disposal to manage and mitigate unsystematic risk:
Diversification: Diversifying a portfolio by holding a broad range of assets across different industries and sectors is one of the most effective ways to reduce unsystematic risk. By spreading investments across various companies, investors can decrease their exposure to any single company’s specific risks.
Asset Allocation: Asset allocation involves distributing investments among different asset classes, such as stocks, bonds, and real estate. A well-structured asset allocation strategy can help balance risk and return, reducing unsystematic risk.
Research and Analysis: Conducting thorough research and fundamental analysis of companies before investing can help identify potential sources of unsystematic risk. This allows investors to make more informed decisions.
Risk Management Tools: Some investors may choose to use risk management tools such as stop-loss orders or options strategies to protect their portfolios from unexpected adverse events related to specific investments.
Active Management: Professional portfolio managers often actively manage portfolios to mitigate unsystematic risk by adjusting holdings in response to changing market conditions and company-specific developments.
Real-World Examples of Unsystematic Risk
Company-Specific Event: A pharmaceutical company faces unsystematic risk when a drug it has heavily invested in fails to gain regulatory approval. This event can significantly impact the company’s stock price and financial stability.
Management Change: A technology company’s CEO unexpectedly resigns due to personal reasons. The uncertainty surrounding the leadership transition can lead to unsystematic risk, causing fluctuations in the company’s stock price.
Supply Chain Disruption: An automobile manufacturer relies on a single supplier for a critical component. If that supplier encounters production issues or goes bankrupt, the manufacturer’s production capacity is at risk, and its stock price may suffer as a result.
Conclusion
Unsystematic risk, also known as company-specific or specific risk, is a crucial concept in investment management. It represents the unique risks associated with individual companies or assets within a portfolio. Investors can reduce or eliminate unsystematic risk through diversification, careful research and analysis, and active management strategies. Recognizing and managing unsystematic risk is essential for constructing a well-balanced and resilient investment portfolio.
Key Highlights – Unsystematic Risk:
Asset-Specific Impact: Unsystematic risk primarily affects individual assets or industries, contrasting with broader market trends.
Diversification Strategy: Spreading investments diversely across assets and sectors helps mitigate unsystematic risk’s impact on a portfolio.
Non-Market Factors: This risk arises from company-specific factors like management decisions, competitive dynamics, and regulatory changes.
Business, Financial, Regulatory Risks: Unsystematic risk stems from business operations, financial structure, and external regulations.
Diversification and Research: Diversifying investments and conducting thorough research are vital for managing unsystematic risk effectively.
Stock Price Volatility: Unsystematic risk leads to significant price fluctuations in individual stocks or securities.
Informed Decisions: Recognizing unsystematic risk enables investors to make informed choices based on detailed risk assessment.
Diversification Benefits: Diversification helps minimize the impact of unsystematic risk on investment portfolios.
Enhanced Portfolio Stability: Managing unsystematic risk enhances portfolio stability and safeguards against significant losses in individual holdings.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
