Unsystematic Risk

Intermediate

Unsystematic risk is the risk specific to a single company or industry, such as a product failure, a lawsuit or poor management, which can be reduced by diversifying across many investments.

Investment risk can be divided into two types. Systematic risk affects the whole market, such as recessions or changes in interest rates. Unsystematic risk, also called specific or idiosyncratic risk, affects individual companies or industries.

Examples of unsystematic risk include a company's factory being destroyed by fire, a failed drug trial for a pharmaceutical company, a product recall, the loss of a major customer, a fraud scandal or new regulations hitting one industry.

For example, an investor holding shares in only one airline is heavily exposed to events affecting that airline. If it suffers a major safety incident, the investor could lose a large portion of their money. An investor holding shares in hundreds of companies across many industries would barely notice the same event.

Because unsystematic risk can be greatly reduced through diversification, financial theory suggests investors are not rewarded with higher expected returns for bearing it. Models such as the Capital Asset Pricing Model therefore focus on systematic risk when estimating expected returns.

This is one of the main reasons diversified funds are widely recommended for individual investors.

For worked examples and full lessons, visit notesbysara.org.