Unsystematic Risk

Unsystematic Risk refers to the portion of an asset’s total risk that is unique to that specific asset or a small group of assets. It is also known as “specific risk” or “idiosyncratic risk,” and it can be eliminated through diversification within a portfolio.

Understanding Unsystematic Risk

Unsystematic risk is primarily associated with individual companies or sectors rather than the overall market. It can arise from various factors, such as:

• Company Performance: Poor earnings reports, management changes, or product failures can significantly impact a specific company’s stock price.
• Industry Trends: Changes in industry regulations, market demand, or competitive landscape may affect companies within a particular sector.
• Events: Company-specific events such as lawsuits, strikes, or corporate acquisitions can introduce risks that do not affect the entire market.

Differentiating Unsystematic Risk from Systematic Risk

Unsystematic risk is distinct from systematic risk, which impacts the entire market due to factors like economic downturns, interest rate changes, or geopolitical events. Diversification across various sectors and assets is the primary method of mitigating unsystematic risk.

Example of Unsystematic Risk

Consider a technology company, XYZ Corp. If XYZ Corp announces a major data breach that results in a loss of customer trust, its stock price may plummet. This incident is specific to XYZ Corp and does not directly affect other companies outside the technology sector. In contrast, a broader economic recession would affect the stock prices of many companies across different sectors, representing systematic risk.

Calculation of Unsystematic Risk

While unsystematic risk itself is qualitative, it can be expressed quantitatively through the Standard Deviation of a security’s returns relative to a benchmark. However, to represent unsystematic risk effectively, the following formula can be used:

Unsystematic Risk = Total Risk – Systematic Risk

Total risk can be represented by the standard deviation of returns, while systematic risk is typically calculated using beta (β), which measures a stock’s volatility in relation to the market. Here’s a simplified representation:

• Total Risk: Standard Deviation of the asset’s returns, say 20%.
• Systematic Risk: Calculated beta is 1.2, with the market’s standard deviation (σ) being 15%. Thus, Systematic Risk = β * σ = 1.2 * 15% = 18%.
• Unsystematic Risk: = 20% – 18% = 2%.

In this case, the unsystematic risk is 2%, indicating that a small portion of the total risk is specific to the asset in question.