Methodology

Stocks

Module 3

Unsystematic Risk

Unsystematic risk is a type of risk that is unique to a specific stock or industry. It is also known as diversifiable risk, as it can be minimised through diversification of investments.

 

Unsystematic risks are varied and may include situations like the introduction of a new competitor into the market, the introduction of a new regulation, a change in the management of a company, or the recall of a faulty product.   It is impossible for investors to keep track of all unsystematic risks, as they can often be unexpected. For example, it is hard for investors to predict that a product recall will take place, as they have no insider information.

 

Having insider information is illegal in most countries, as it gives an investor an advantage when it comes to certain unsystematic risks. If an investor knows that something is going to happen from inside of a company, then it would be easy for them to use that information to make a profit or to avoid losses.

 

Obviously, most investors do not have access to insider information, exposing their capital to a host of unsystematic risks.

The 5 types of Unsystematic Risk

There are 5 main types of unsystematic risk, which would include business risk, financial risk, operational risk, strategic risk and legal risk.   

 

Business risk involves any event that disrupts the ability of a company to do business effectively. There are two main types, internal and external. Internal business risk occurs when the management of a company fail to protect their business (i.e. they fail to pay suitable salaries, which leads to a strike from employees). Meanwhile, an external business risk occurs when something happens outside of the company which damages the business (i.e. flooding makes it impossible to use an office).

 

Financial risk involves the mismanagement of the finances of the company, putting at risk the future of the company. For example, a company may take on too much debt that they can’t repay, which forces the company to close.

 

Operational risk occurs when a company has not taken steps to protect the way that a business runs. For instance, it could be that the management team have not replaced a particular machine, which goes on to break within a shift, with no replacement in place.

 

Strategic risk happens when the management team of a business have failed to effectively manage the strategy of the business, forcing it to operate in a sector that is declining. This is a problem as the company will not grow and will reduce in size instead. This usually happens to companies that have entered the decline phase of the business cycle.

 

Finally, legal risk involves the introduction of a new law or regulation that threatens the future of a business. An example would be if people were forced to drive electric cars only, resulting in the instant demise of car companies that do not offer electric cars.  

Unsystematic risk in practice

As previously mentioned, unsystematic risks are unpredictable in many cases. Therefore, the best solution that an investor has is to invest in a range of companies that operate in difference industries. As with in many areas, diversification is the key when it comes to countering unsystematic risk. 

 

All companies are exposed to unsystematic risk, with more mature companies experiencing them less frequently. More established companies are more experienced at overcoming such risks, which is partly the reason why those companies have more stable stock prices.

 

Companies that experience a lot of unsystematic risks will experience vast changes in their stock price, with investors reacting to events as they unfold. If the unsystematic risks that a company experiences are severe enough, then it could even threaten the future of the business.

 

So, from an investor’s viewpoint, diversifying is the key to overcoming unsystematic risks, with more mature companies being preferred over less developed companies.

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