Unsystematic Risk Definition + Examples

Knowing the differences between these types of risks and techniques to manage them can enhance portfolio management. Imagine you invest in a manufacturing company that produces electronic goods. Due to a semiconductor shortage, the company faces supply chain disruptions, bringing its entire manufacturing facility to a halt. A regulatory policy change by the Reserve Bank of India leads to increased scrutiny and disruption of the company’s operations.

By limiting exposure to any single investment, diversification aims to reduce unsystematic risk. For this reason, unsystematic risks can be broad enough to apply to many different businesses at once. What is important is that an unsystematic risk is not inherent to every security or at least not a great majority of securities. Moreover, investors should be able to diversify away unsystematic risks by strategically targeting a wide enough range of holdings in their respective portfolios. Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. Unsystematic risk is the risk that is unique to a specific company or industry.

What are Unsystematic Risk Examples?

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1. Often used interchangeably with the term “idiosyncratic risk”, unsystematic risk can be mitigated via portfolio diversification.
2. Such factors as a company’s management capabilities, financial structure, labor strikes, and consumer preferences cause unsystematic risk.
3. Most unsystematic risks are related to errors in entrepreneurial judgment.
4. Managing risk helps investors minimize the chances of significant losses and increase the chances of achieving their investment goals.
5. Unsystematic risks are uncertainties surrounding a specific industry or a company.
6. Understanding both types of risk is key for asset allocation and risk management in investing.

Financial risk

This type of risk is unique to a particular company or industry, in contrast to market or systematic risk that affects all companies. The most common examples of unsystematic risk are the risks that are specific to an individual firm. Examples can include management risks, litigation risks, location risks, and succession risks. Unlike systematic risk, which unsystematic risk example affects the broader market or an entire asset class (e.g. equity, credit, bond, commodities), unsystematic risk is specific to a particular financial asset or industry.

These factors are beyond the control of the business or investor, such as economic, political, or social factors. Meanwhile, events that affect a specific company are unsystematic risks, such as a labor strike or the FDA denying a new drug. The total risk for investments is unsystematic risk plus systematic risk. Unsystematic risk is a risk specific to a company or industry, while systematic risk is the risk tied to the broader market—which is why it’s also referred to as market risk. Systematic risk is attributed to broad market factors and is the investment portfolio risk that is not based on individual investments. In summary, systematic risks arise from macroeconomic factors and affect the wider market, while unsystematic risks are unique to individual assets and can be managed through diversification.

In contrast, a well-diversified portfolio can neutralize unsystematic risks, as negative events impacting one company are balanced by positive results elsewhere in the portfolio. Some common types of unsystematic risk include business risk, financial risk, operational risk, strategic risk, and legal or regulatory risk. Systematic risk is a non-diversifiable risk or a measure of overall market risk.

Unsystematic Risk Scenarios in Individual Investments

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. However, while diversification in theory can substantially reduce the volatility in a portfolio’s returns, it is still not an absolute certain guarantee against potential losses. Broadly put, risk is an inevitable part of investing, regardless of the hedging and risk mitigation strategies utilized. Operational risk is tied to operations and the potential for failed systems or policies.

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Others operate with an incomplete picture of what risk really means and take unnecessary chances. Broad market exposure, hedging against stock portfolio risk, and market speculation. Vaia is a globally recognized educational technology company, offering a holistic learning platform designed for students of all ages and educational levels. We offer an extensive library of learning materials, including interactive flashcards, comprehensive textbook solutions, and detailed explanations.

1. In contrast, a well-diversified portfolio can neutralize unsystematic risks, as negative events impacting one company are balanced by positive results elsewhere in the portfolio.
2. Advisors can then recommend appropriate asset allocations across stocks, bonds, cash, and other securities to align with an investor’s financial goals and comfort with risk.
3. Unsystematic risk refers to firm-specific uncertainties like lawsuits, strikes, defective products, etc.
4. Investors can reduce their exposure to unsystematic risks by diversifying their portfolio.
5. Unlike market-wide risks, this type of risk can be reduced by diversifying investments across different securities, limiting exposure to any single asset’s performance.
6. Examples of unsystematic risk include a company’s financial mismanagement, labor strikes, and product recalls.

Key examples of unsystematic risk include management inefficiency, flawed business models, liquidity issues, regulatory changes, or worker strikes. Since unsystematic risks are unique to each company, they can be minimized through diversification. The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Asset Allocation to Manage Systematic Risk

The cutting-edge technology and tools we provide help students create their own learning materials. StudySmarter’s content is not only expert-verified but also regularly updated to ensure accuracy and relevance. A new government policy imposing stringent environmental controls can lead to increased operational costs, impacting all companies within the sector.

Systematic risk refers to the risk inherent in the entire market or market segment. It is the risk that cannot be avoided through diversification and affects the overall market, not just individual stocks or industries. Securities or other financial instruments mentioned in the material posted are not suitable for all investors. Before making any investment or trade, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice. Systematic, in this context, refers to the economic, political, and sociological factors that impact all securities to varying degrees. Examples of unsystematic risk help in understanding the practical implications of industry and company-specific uncertainties.