3.2 Unsystematic (Company-Specific) Risk

Unsystematic risk (also called diversifiable risk, specific risk, unique risk, or idiosyncratic risk) is risk that affects a particular company, industry, or sector. Unlike systematic risk, unsystematic risk can be reduced or eliminated through proper diversification.

The Key Distinction

Affects: Systematic Risk - Entire market; Unsystematic Risk - Specific companies/industries

Diversifiable? Systematic Risk - No; Unsystematic Risk - Yes

Measured by: Systematic Risk - Beta; Unsystematic Risk - Not compensated by market

Examples: Systematic Risk - Market crash, inflation; Unsystematic Risk - CEO departure, product recall

Types of Unsystematic Risk

1. Business Risk

Business risk is the risk associated with a company's operations, management, and competitive position.

Management quality: Poor decisions, executive turnover

Competition: New competitors, market share loss

Product issues: Recalls, obsolescence

Labor issues: Strikes, unionization

Industry changes: Technological disruption

Operational problems: Supply chain failures

Example: A pharmaceutical company's drug fails clinical trials - this affects only that company, not the entire market.

2. Financial Risk

Financial risk is the risk arising from a company's use of debt (leverage) in its capital structure.

Low debt: Lower financial risk. Implications: More financial flexibility

High debt: Higher financial risk. Implications: Fixed interest payments required; bankruptcy risk

Key Point: Financial risk increases with leverage because:

- Interest must be paid regardless of profits

- Debt covenants restrict flexibility

- High debt increases bankruptcy probability

- Earnings become more volatile

Measured by: Debt-to-equity ratio, interest coverage ratio

3. Credit Risk (Default Risk)

Credit risk is the risk that a borrower fails to make required payments on debt obligations.

Investment Grade (BBB/Baa and above): Lower default risk. Example: U.S. Treasury, Apple

High Yield/Junk (BB/Ba and below): Higher default risk. Example: Speculative companies

Credit Rating Agencies: Moody's, S&P, Fitch

S&P AAA / Moody's Aaa: Highest quality

S&P AA / Moody's Aa: High quality

S&P A / Moody's A: Upper medium grade

S&P BBB / Moody's Baa: Medium grade (lowest investment grade)

S&P BB / Moody's Ba: Speculative

S&P B / Moody's B: Highly speculative

S&P CCC / Moody's Caa: Substantial risk

S&P D / Moody's C: In default

4. Liquidity Risk

Liquidity risk is the risk of not being able to sell an investment quickly at a fair price.

Characteristics of Illiquid Investments: Wide bid-ask spreads - Penny stocks; Low trading volume - Thinly traded bonds; Long settlement periods - Real estate; Lock-up periods - Private equity, hedge funds; No active market - Limited partnerships

Liquidity Spectrum:

More Liquid: Large-cap stocks; Treasury securities; Money market funds; Major ETFs

Less Liquid: Small-cap stocks; Corporate bonds; Real estate; Private equity

5. Legislative/Regulatory Risk

Legislative risk is the risk that laws or regulations will negatively affect a specific company or industry.

Healthcare: Drug pricing legislation

Financial services: Banking regulations

Energy: Environmental regulations

Technology: Privacy laws, antitrust

Tobacco: Advertising restrictions

6. Concentration Risk

Concentration risk is the risk from lack of diversification - having too much exposure to a single investment.

Examples of Concentration Risk:

- Employee with 80% of portfolio in company stock

- Investor holding only technology stocks

- Retirement savings entirely in one mutual fund

The Power of Diversification

Diversification is the primary tool for reducing unsystematic risk:

1 stock: 100% unsystematic risk remaining

10 stocks: approx. 50%

20 stocks: approx. 25%

30+ stocks: Minimal (approx. 5-10%)

Research Finding: Approximately 20-30 uncorrelated stocks can eliminate most unsystematic risk. Beyond that, additional diversification provides diminishing benefits.

Types of Diversification

Within asset class: Own stocks across multiple industries. Risk Reduced: (within stocks)

Across asset classes: Stocks, bonds, real estate

Geographic: Domestic and international

Time (dollar-cost averaging): Spread purchases over time

In Practice: How Investment Advisers Apply This

Portfolio construction:

- Ensure adequate diversification (20+ securities minimum)

- Diversify across industries and sectors

- Consider correlation between holdings

- Watch for concentration in client-held assets (company stock)

Client education:

- Explain that diversification eliminates company-specific risk

- Help clients understand they shouldn't panic over single-company news

- Discuss the dangers of concentrated positions (employer stock)

On the Exam

The Series 65 exam tests your understanding of:

1. Definition of unsystematic risk and that it CAN be diversified away

2. Types: Business, financial, credit, liquidity, legislative, concentration

3. Relationship between diversification and unsystematic risk reduction

4. How many stocks are needed to diversify (20-30)

5. Credit ratings and what they measure

Common formats include identifying which risks are diversifiable and understanding credit risk.

Key Takeaways

- Unsystematic risk affects specific companies and CAN be diversified away

- Business risk relates to company operations and management

- Financial risk increases with leverage (debt)

- Credit/default risk is the risk of non-payment on debt

- Liquidity risk is the difficulty of selling quickly at fair price

- 20-30 uncorrelated stocks eliminate most unsystematic risk

- Diversification reduces unsystematic risk but NOT systematic risk

- Credit ratings (S&P, Moody's) measure default risk