Unsystematic Risk vs Systematic Risk – Definition – Meaning – Example

Unsystematic Risk – A Closer Look

Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. For example, a new competitor in an industry has the potential to take significant market share from existing companies.  Other examples include regulatory changes that could drive down company sales, a shift in management, or a product recall.

Investors may be able to anticipate some sources of unsystematic risk.  However, it is impossible to be aware of all possibilities or when they might occur. For example, investors in healthcare stocks may be aware that a major shift in health policy is on the horizon.  Yet, they cannot know in advance the specific details of the new laws and how companies and consumers will respond. The gradual adoption and then potential repeal of the Affordable Care Act was first written into law in 2010.  This made it very challenging for some investors in healthcare stocks to anticipate and place confident bets on the direction of the industry or specific companies.

Examples of unsystematic risk include things, such as strikes, outcomes of legal proceedings, or natural disasters. This risk is also known as a diversifiable risk since it can be reduced by sufficiently diversifying a portfolio. There isn’t a formula for calculating unsystematic risk; instead.  Instead, it must be derived by subtracting the systematic risk from the total risk.  (Source: investopedia.com)

• Regulatory change – A change in regulations that impacts one industry
• Competition – The entry of a new competitor into a market
• Product recall – A company is forced to recall one of its products
• Fraud – A company is found to have prepared fraudulent financial statements
• Union strike –  union targets a company for an employee walkout
• Governmental action – A foreign government expropriates the assets of a specific company

Industry-wide Unsystematic Risk

Unsystematic risk can be a hazard that is specific to an entire industry. The presence of unsystematic risk means that industry-wide participants are at risk of adverse changes. For investors, this risk can be reduced by diversifying one’s investments across multiple industries. By doing so, the risks associated with each security in the portfolio will tend to cancel each other out. As a result, the best way to reduce unsystematic risk is to diversify broadly. For example, an investor could invest in securities from a number of different industries.  Additionally, he could hold other asset types as well like municipal and treasury bonds.

Company-Specific Unsystematic Risk

• Business risk – Both internal and external issues may cause business risk. Internal risk relates to the operational efficiency of the business. For example, management fails to take out a patent to protect a new product.  As a consequence, it could result in the loss of competitive advantage.
• Financial risk – Financial risk relates to the capital structure of a company. A company needs to have reasonable debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow.  As a consequence, an exchange could suspend the company’s stock or prevent a company from trading.
• Operational risk – Unforeseen events such as a breakdown in the supply chain or a critical error being overlooked in the manufacturing process can shut down operations. A security breach could expose confidential information about customers or other types of key proprietary data to criminals.
• Strategic risk – A strategic risk may occur if a business is trapped selling goods or services in a dying industry.  A company may also encounter this risk by entering into a flawed partnership with another firm or competitor.  Ultimately, strategic decisions significantly affect future prospects for growth.
• Legal risk – Legal as well as regulatory risks can expose a company to liabilities and potential lawsuits.  Legal actions can originate from customers, suppliers, and competing firms. Enforcement actions from government agencies and changes in laws can also be difficult to foresee.   (Sources: investopedia.com & accountingtool.com)

Unsystematic Risk vs Systematic Risk

Systematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or industry. Systematic risk is caused by external factors that are outside the organization. Market-wide, all investments or securities are subject to systematic risk.  As a result, it is a non-diversifiable risk. Meaning systematic risk cannot be diversified away by holding a large number of securities. Systematic risk includes market risk, interest rate risk, purchasing power risk, and exchange rate risk.

Market Risk

Market risk is caused by the herd mentality of investors, i.e. the tendency of investors to follow the direction of the market. Hence, market risk is the tendency of security prices to move together. If the market is declining, then even the share prices of good performing companies fall. Market risk constitutes almost two-thirds of total systematic risk. Therefore, sometimes the systematic risk is also referred to as market risk. Market price changes are the most prominent source of risk in securities.

Interest Rate Risk

Interest rate risk arises due to changes in market interest rates. In the stock market, this primarily affects fixed income securities because bond prices are inversely related to the market interest rate. In fact, interest rate risks include two opposite components: Price Risk and Reinvestment Risk. Both of these risks work in opposite directions. Price risk is associated with changes in the price of security due to changes in interest rate. Reinvestment risk is associated with reinvesting interest/ dividend income. If price risk is negative (i.e., fall in price), reinvestment risk would be positive (i.e. increase in earnings on reinvested money). Interest rate changes are the main source of risk for fixed income securities such as bonds and debentures.

Inflation Risk

Purchasing power risk arises due to inflation. Inflation is the persistent and sustained increase in the general price level. Inflation erodes the purchasing power of money, i.e., the same amount of money can buy fewer goods and services due to an increase in prices. Therefore, if an investor’s income does not increase in times of rising inflation, then the investor is actually getting lower income in real terms. Fixed income securities are subject to a high level of purchasing power risk because income from such securities is fixed in nominal terms. It is often said that equity shares are good hedges against inflation and hence subject to lower purchasing power risk.

Exchange Rate Risk

In a globalized economy, most companies have exposure to foreign currency. Exchange rate risk is the uncertainty associated with changes in the value of foreign currencies. Therefore, this type of risk affects only the securities of companies with foreign exchange transactions or exposures such as export companies, MNCs, or companies that use imported raw material or products. (Source: corporatefinanceinstitute.com)

Dealing with Unsystematic Risk

Diversification involves owning a variety of company stocks across different industries.  In addition, owning other types of securities in a variety of asset classes, such as Treasuries and municipal securities.  Wide diversification is the best strategy to protect investors from company-specific or industry-specific risks. For example, investors who owned nothing but airline stocks would face a high level of unsystematic risk. They would be vulnerable if airline industry employees decided to go on strike. This event would negatively impact airline stock prices, even temporarily. Simply the anticipation of this news could be disastrous for a transportation portfolio.

Adding uncorrelated holdings to a portfolio, such as stocks outside of the transportation industry, would spread out air-travel-specific concerns. Unsystematic risk, in this case, affects not only specific airlines.  It also affects several support industries, such as large food companies, with which many airlines do business. Adding other asset classes would help diversify away from public equities.  For example, by adding US Treasury Bonds as additional protection from fluctuations in stock prices.  However, even a portfolio of well-diversified assets cannot escape all risk. The portfolio will still be exposed to systematic risk, which refers to the uncertainty that faces the market as a whole. (Source: investopedia.com)

Examples of Market-wide Systematic Risk

Changes to Laws

Changes to government policies that affect all sectors are examples of systematic risks. For example, assume that government increases the minimum employee salary by 100%. You know employee cost is a major spend for most of the companies. Hence, such a policy change will affect companies across many sectors. There may be companies with high degrees of automation that escape the crisis. But, when most other companies struggle, there will be widespread layoffs. Overall, the purchasing power of people will decrease. Therefore, this type of chain reaction leads to price corrections across the market. A major change in employee policy will have a huge impact on the economy as a whole.

Interest Rate Hikes

Interest rate hikes always make headlines for a reason. It is an impact that will be felt widely across many industries. An increase in interest rates reduces the number of borrowers from banks. As a result, free money in circulation decreases. Such changes ultimately lead to an increase in inflation.  Which, beyond a certain limit is not good for the economy. Major hikes in rates take place as a result of unavoidable circumstances and have an avalanche effect on the economy and markets as a whole. Impactful rate hikes are perfect examples of systematic risks.

Currency Value Changes

No country operates in isolation. A country’s economy is highly dependent on its healthy trade with other countries. Volatile changes to a currency’s value affect the economy as a whole and is an example of systematic risk. Usually, big changes to the currency values are a result of some other major changes in foreign policies. Even huge tax reforms may lead to currency value changes.

Economic Recessions

There can be multiple reasons for recessions. They may be due to a failure of banking systems, bubble due to overvaluation in big markets, conflicts between countries, etc. There were at least 11 economic recessions in the US since 1948. And every time major benchmark indexes fell from the deep impact of each recession on the economy.  (Source: netcials.com)

Probability and Expected Value

The expected value or return of a portfolio is the sum of all the possible returns multiplied by the probability of each possible return. One form of risk is the amount of deviation and the probability of that deviation from the expected return. Portfolio risk is reduced by mitigating systematic risk with asset allocation.  The unsystematic risk is mitigated with diversification. Mitigation of systematic and unsystematic risk allows a portfolio manager to put higher risk/reward assets in the portfolio without accepting additional risk. This is called portfolio optimization.

In other words, a manager must be willing to accept a given amount of risk. The total risk of the portfolio can be reduced through proper asset allocation and diversification. However, a certain degree of market-wide and economy-wide risk is inevitable.

Final Words

Systematic and unsystematic risks can be partially mitigated with risk management solutions.  These include strategies like asset allocation, diversification, and valuation timing. Managed properly, an investor can increase portfolio returns and reduce risk to optimize an investment portfolio.

When talking about systematic risks, the context is important. A risk that looks widespread when observed from one country may look different from another country. For example, even during the recession of 2008 to 2010 developing economies like India and China performed far better than the rest. The impact of the recession was minimal for those countries. (Source: netcials.com)