2.19 Non-Systematic Risk

Non-Systematic Risk (Unsystematic Risk)

While systematic risk affects the entire market, unsystematic risk (also called non-systematic, diversifiable, or company-specific risk) affects only individual companies or industries. The key difference: unsystematic risk CAN be reduced or eliminated through diversification.

What Is Unsystematic Risk?

Unsystematic risk is risk specific to a company, industry, or sector that does not affect the broader market. It results from factors unique to a particular investment.

Key Characteristics

Scope: Affects individual companies or sectors

Diversifiable? Yes - can be reduced or eliminated

Examples: Management changes, product recalls, strikes

Measurement: Standard deviation (total risk)

Compensation: Investors are NOT compensated for this risk

Key Concept: Because unsystematic risk can be eliminated through diversification, investors do not receive extra return for bearing it.

Types of Unsystematic Risk

Business Risk

Business risk relates to a company operations and ability to generate revenue.

Competition: New competitor enters market

Technology: Products become obsolete

Management: Poor strategic decisions

Labor: Strikes or workforce issues

Supply chain: Component shortages

Financial Risk

Financial risk relates to how a company finances its operations.

Debt levels: High leverage increases default risk

Interest coverage: Inability to pay interest obligations

Cash flow: Insufficient liquidity

Credit rating: Downgrade increases borrowing costs

Key Point: Companies with high debt-to-equity ratios have higher financial risk. If earnings decline, they may struggle to meet debt obligations.

Credit Risk (Default Risk)

Credit risk is the risk that a bond issuer will fail to make interest or principal payments.

AAA/AA: Very low

A/BBB: Low to moderate

BB and below (junk): High

D: In default

Call Risk

Call risk is the risk that a bond will be redeemed before maturity, usually when interest rates fall.

- Issuer calls bonds to refinance at lower rates

- Investor must reinvest at lower current rates

- Affects callable bonds and preferred stock

Liquidity Risk

Liquidity risk is the risk that an investment cannot be quickly sold at fair value.

Highly Liquid: Large-cap stocks; Treasury securities; ETFs

Less Liquid: Small-cap stocks; Municipal bonds; Limited partnerships

Legislative/Regulatory Risk

Legislative risk is the risk that new laws or regulations will negatively impact an investment.

- Changes in tax laws

- Industry-specific regulations

- Environmental requirements

- Trade restrictions

Event Risk

Event risk is the risk from unexpected events affecting a specific company.

- Mergers and acquisitions

- Natural disasters damaging facilities

- Lawsuits and legal judgments

- Management fraud or scandals

Reducing Unsystematic Risk: Diversification

Diversification is the primary tool for reducing unsystematic risk.

How Diversification Works

By spreading investments across many securities, the impact of any single company problems is reduced.

1 stock: Maximum exposure

5 stocks: Moderate reduction

10 stocks: Significant reduction

20+ stocks: Most eliminated

30+ stocks: Essentially eliminated

Diversification Methods

By sector: Technology, healthcare, finance, etc.

By company size: Large-cap, mid-cap, small-cap

By geography: Domestic, international, emerging markets

By asset class: Stocks, bonds, real estate

By maturity: Short-term, intermediate, long-term bonds

Systematic vs. Unsystematic Risk Comparison

Also called: Systematic Risk - Market risk; Unsystematic Risk - Diversifiable risk

Scope: Systematic Risk - Entire market; Unsystematic Risk - Individual companies

Diversifiable? Systematic Risk - No; Unsystematic Risk - Yes

Examples: Systematic Risk - Inflation, interest rates; Unsystematic Risk - Business failures, recalls

Measurement: Systematic Risk - Beta; Unsystematic Risk - Standard deviation

Compensation: Systematic Risk - Yes, higher expected return; Unsystematic Risk - No, can be eliminated

Total Risk

Total risk is the combination of systematic and unsystematic risk:

Total Risk = Systematic Risk + Unsystematic Risk

- Measured by standard deviation

- A diversified portfolio has mostly systematic risk remaining

- An undiversified portfolio has both types

Practical Application

For Individual Stock Investors

- Diversify across at least 20-30 stocks

- Spread across different sectors

- Consider international exposure

- No single position should dominate

For Fund Investors

Mutual funds and ETFs provide instant diversification:

- S&P 500 index fund = 500 large-cap stocks

- Total stock market fund = thousands of stocks

- One fund can eliminate most unsystematic risk

Key Takeaways

- Unsystematic risk is company-specific and diversifiable

- Main types: business, financial, credit, call, liquidity, regulatory

- Diversification reduces unsystematic risk

- 20-30 stocks can eliminate most unsystematic risk

- Investors are NOT compensated for unsystematic risk

- After diversification, only systematic risk remains