Unsystematic Risk

Introduction

Unsystematic Risks are risk that are not shared with the wider market or industry. Unsystematic risk are often specific to an individual company due to their management, financial obligation or location. Unsystematic risk can be reduced by diversifying one’s investments.

Unsystematic risk is unique and is caused due to internal factors. It cannot be avoided and controlled. It can be minimized by diversification in the sense of an investment portfolio.

What is Unsystematic Risk?

Unsystematic Risk can be defined as  an uncertainty of an investment in a firm or industry. Types of unsystematic risk comprise a new market competitor or ability to take substantial market share from the company being invested in.  Unsystematic risk is also known as diversifiable risk or specific risk or residual risk. Investors in this case can generally gauge possibilities of unsystematic risk but it is not possible to be totally aware regarding when and how it will happen. For instance a firm may generate high profits in case of which the stock prices go up. On the other hand some other firm may generate low profits which make its stock prices go up or down.

Types of Unsystematic Risk

The following are the types of Unsystematic Risk

1. Business Risk

Business Risk includes internal factors that risks the revenue and performance of the company. This includes not obtaining proper copyright for a new brand or a patent for a new product. Thereby the competitor can have a freehand to introduce the same product or use the same brand. Business risk can occur due to external factors also known as government agencies that may prohibit a drug that a company sells.

2. Finance Risk

Financial Risk means risk related to company’s capital structure. The capital structure of all the companies usually has a mix of debt and equity. To derive maximum benefits from the capital structure a company must maintain and strive to achieve optimal mix of debt and equity. If the company fails to maintain balance between the two, it could effect cash flows and earnings. Therefore the risk arises from the sub-optimal level of the debt equity mix.

3. Operational Risk

Operational Risk arises due to negligence or unforeseen events, such as supply chain problems, breakdown of machinery, data breaches etc. Operational risk includes risk from day to day operations and companies take up preventive measures regularly to avoid equipment related issues.

4. Strategic Risk

The risk involves management’s failure to take right decision regarding its product or services. An example of this is the company entering in to partnership with a fraud entity. Another example is management could not visualize in advance or not being able to change course when the product is not performing well.

5. Legal and Regulatory Risk

The legal risks relate to changes in laws or regulations that go against the company or industry. Usually such changes increase cost or make operations more difficult. These risks also include companies violating laws.

Examples of Unsystematic Risk

Most Unsystematic Risk are related to errors in entrepreneurial judgement. Suppose a watch manufacturing company performs market research and finds that consumers want small watches instead of big straps and the  products are altered accordingly. Later on the company finds it that the consumer actually needs large watches instead of small.  Now the existing inventory goes unsold or it has to be sold at a major loss. This can damage the stock price.

Another example of unsystematic Risk is the litigation risk which the company faces due to legal action. Some companies face greater litigation risk. For example a company whose products are more likely to be defective will face more litigation and action suits than the other companies

Advantages

• This risk relates to only a particular company or industry and not the overall economy
• This type of risk can be avoided or reduced by diversifying the portfolios.
• The factors that lead to risk are internal. Therefore internal monitoring and measures can help avoid or minimize the risk.
• The severity of the unsystematic risk is usually lower than the systematic risk. The duration of the impact is also lower than the systematic risk.
• As it is limited to company or industry the number of people affected is smaller.

Disadvantages

• Such a risk can impact specific industry and cause disruption even when the economy is doing well.
• Although the risk is specific to a company or industry it takes time to return to normal. If the issue arises in between the duration could be even longer.
• Unsystematic risk sometimes leads to permanent change in the preference of the customer. If it happens such risk could have serious repercussions on the market of such a company or industry.
• Unsystematic risk are usually not repetitive. This makes the management to plan as they can face new problem next time.
• This type of risk can have severe impact on the workers , employees confidence and they can start to feel job insecurity.
• Sometimes the company needs to spend massive money, time and resources to overcome or manage such risks.
• Since it does effect the economy or effect only fewer people, state intervention is rare. There will be little or no financial help from the government in such cases.
• It can sometimes bring negative impact to the economy.
• Those firms who are interdependent have an adverse impact on the other firms and services.

Limitations          

The Limitations of Unsystematic Risks include :

1. Unpredictable

Unsystematic Risks are affected by number of factors and therefore investors may not be able to predict in advance which stock it will effect. This is a barrier in taking decisions for the investors.

2. Not easily found out

This type of risk is caused mainly due to internal factors most of the time, and what can cause them cannot always be known through the publicly available information and therefore investors may not always be able to quantify. Therefore it is difficult for the investors to find out such problems.

Unsystematic Risk v/s Systematic Risk

Conclusion

Thus Unsystematic risk are diversifiable risks which means if you buy shares across of different companies it can reduce risk. Unsystematic risk are often tied to a specific company or industry and it can be avoided by building a well diversified portfolio.

It is dynamic because the problems that each company faces are unique and it has no correlation with entire economy. As a result the government involvement is very less and private players need to handle the issues on their own. Therefore portfolio diversification is suggested to avoid deep shocks.