The stock market always has an element of risk involved. This risk can be classified into two major categories — systematic risk and unsystematic risk. Understanding what they are is crucial to making informed financial decisions. In this article, we are going to explore unsystematic risk, its various types and its relationship with systematic risk.
What is unsystematic risk
Unsystematic risk, also called diversifiable risk, involves risks unique to a particular company or industry, such as those related to management, finances, or location. Unlike systematic risks that impact the entire market and are harder to avoid, unsystematic risks can be reduced by diversifying your investments.
Types of unsystematic risks
From legal and regulatory changes to operational downtimes, all kinds of uncertainties specific to a company or industry are labelled as unsystematic risks. Here is a brief overview of some of the most common types
Business risk
Business risk includes all the risks that threaten a company’s revenue, profitability and overall performance. Business risk could arise due to internal factors like production disruptions or external factors like changes in consumer preferences.
Financial risk
Financial risk includes the risks associated with the financial structure of a company. A less-than-ideal or weak financial structure due to an incorrect or sub-optimal debt-equity mix is one of the major financial risks a company faces.
Regulatory risk
Regulatory risk includes disruptions that are caused due to changes in the laws, regulations and policies governing a company or an industry. A change in corporate taxation and environmental regulations are a couple of examples of regulatory risk.
Management risk
Management risk is the uncertainty surrounding the competency and decisions of a company's key management team. Some of the factors that contribute to management risk involve poor strategic choices, ineffective leadership and corporate governance issues.
Industry risk
Industry risk involves all the factors that affect an entire industry. Generally, industries that are characterised by rapid innovation and stringent regulations often have significantly higher industry risk.
Strategic risk
Strategic risk stems from the uncertainty surrounding the management’s business strategy. For example, a company entering into a strategic partnership with another entity at unfavourable terms is a form of strategic risk.
Operational risk
Operational risk involves all the factors that threaten the day-to-day operations of the company. This includes the breakdown of critical machinery, data breaches and supply chain disruptions.
Examples of unsystematic risk
Now that you have seen the various types of unsystematic risk, let us look at a couple of hypothetical examples to better understand the concept.
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. The uncertainty surrounding the supply chain is an operational risk, which is a type of unsystematic risk.
Alternatively, let us say that you invest in a fintech company that provides a range of financial services. A regulatory policy change by the Reserve Bank of India leads to increased scrutiny and disruption of the company’s operations. This is an example of regulatory risk.
Advantages of unsystematic risk
Although it may be surprising, unsystematic risk has a few advantages. Let us look at some of them.
- Unsystematic risk only affects a specific company or an industry. The larger economy and the market would remain unaffected by these risks.
- Since these risks are very specific, they may not be as severe as systematic risks. Furthermore, the impact of unsystematic risk is also much lower.
- Unsystematic risk can be managed and mitigated to a certain extent through proper portfolio diversification.
Disadvantages of unsystematic risk
Unsystematic risk can be highly disadvantageous to investors. Understanding its drawbacks can help you manage it better. Here are a couple of key disadvantages.
- Since there are so many types of unsystematic risks, accurately predicting or quantifying them can be very challenging.
- Unsystematic risk can be reduced to a certain extent through portfolio diversification. However, achieving adequate diversification may lead to increased costs, which can impact your overall returns.
Unsystematic risk vs systematic risk
Systematic and unsystematic risk are two entirely different types of risk, each with its own set of characteristics. The following table outlines the key differences between the two.
| Particulars | Systematic risk | Unsystematic risk |
| Scope | Affects the entire market or economy | Specific to a company or an industry |
| Management | Cannot be managed or mitigated | Can be managed through portfolio diversification |
| Source of risk | Macroeconomic factors like economic indicators, interest rates and geopolitical events | Company or industry-specific factors like regulatory changes and management decisions |
| Predictability | Can be measured and predicted | Cannot be accurately predicted or measured |
| Controllability | Beyond the control of the company and investors | Well within the control of the company |
Conclusion
Unsystematic risks are uncertainties surrounding a specific industry or a company. Although such risks cannot be accurately predicted, they can be managed to a certain extent through portfolio diversification. However, it is essential to understand that despite strong risk management measures, unsystematic risks cannot be eliminated entirely.
