Unsystematic Risk
Unsystematic risk refers to risks that are unique to a particular company or industry and are not reflected in the overall market. These risks are also known as idiosyncratic risks.
Examples of unsystematic risk:
- Company-specific risks:
- Financial difficulties of a particular company
- Product recalls or liabilities
- Company management issues
- Industry-specific risks:
- Changes in industry regulations
- Technological advancements that impact the industry
- Economic conditions specific to the industry
Examples:
- A company that manufactures electronics may face higher unsystematic risk than a company that manufactures pharmaceuticals, because the electronics industry is more susceptible to fluctuations in demand and technological obsolescence.
- A company in the automotive industry may face higher unsystematic risk than a company in the technology industry, because the automotive industry is more affected by changes in consumer preferences and economic conditions.
Impact on Investment:
Unsystematic risk can have a significant impact on investment returns. Investors who are exposed to high levels of unsystematic risk may experience more volatility in their returns than those who are exposed to lower levels of risk.
Measures to Mitigate Unsystematic Risk:
- Diversification: Invest in a variety of companies or industries to spread risk across different sources.
- Long-term investments: Hold investments for a longer period of time to reduce the impact of short-term fluctuations.
- Value investing: Invest in undervalued stocks that have the potential for higher returns.
Conclusion:
Unsystematic risk is an important concept in investment. It is important to understand the unsystematic risk associated with different investments to make informed financial decisions.
FAQs
What is meant by unsystematic risk?
Unsystematic risk, also known as specific or diversifiable risk, refers to the risk that affects a particular company or industry, rather than the entire market. This type of risk can often be reduced or eliminated through diversification.
What are examples of unsystematic risk?
Examples of unsystematic risk include business risk, financial risk, operational risk, regulatory risk, and legal risk. These are risks that are specific to a company or industry, such as a company facing a lawsuit or new regulations impacting a particular sector.
Is inflation an example of unsystematic risk?
No, inflation is a systematic risk because it affects the entire economy and impacts all industries broadly. Unsystematic risk is specific to individual companies or sectors, not the economy as a whole.
What is unsystematic risk in the context of the Capital Asset Pricing Model (CAPM)?
In CAPM, unsystematic risk is the portion of a securityโs total risk that can be diversified away by holding a diversified portfolio. CAPM assumes that investors are only compensated for systematic risk, which cannot be diversified away, as measured by the asset’s beta.
