Unsystematic risk is a risk that does not impact on overall economy or industry. Unsystematic risk is specific to a single company due to its management, financial obligations, and many more. You can reduce it as much as possible by diversifying (think of it as an investment portfolio).
What is Unsystematic Risk?
Unsystematic risk is also called specific risk or unique risk that is inherent and specific to a company or industry. Unsystematic risk is unique or peculiar to a company or industry and can be reduced through diversification, while systematic risk affects all companies or industries.
An unsystematic risk occurs from any such events the company is unprepared for and which interfere with regular business operations. It arises due to internal factors such as raw material scarcity, labour strikes, management inefficiency, etc.
Example of Unsystematic Risk
Example #1
Suppose, IndiGo Airline's staff announces a strike and operations are stopped for a period. But demand for the passenger has remained the same. Now if you hold shares in IndiGo Airlines, your holdings will get directly hit for such an event is called unsystematic risk. But overall economic growth remains the same. Thus the crisis can be sorted out by taking with the stuff.
Example #2
Assume that fund A has a 10% stake in Indian agriculture. Commodity prices has surged due to poor harvesting circumstances throughout India, which has resulted in a decline in demand and lower farmer yields.
This unsystematic risk is related to the agriculture industry in India. Hence, the fund manager can divert the stake to the agriculture industry. If the fund manager finds any other investment opportunist and will invest it.
Types of Unsystematic Risk
- The unsystematic risk affecting a specific stock or industry arises from two sources:
- The operating environment of the company is referred to as "business risk".
- The financing pattern adopted by the company is known as "financial risk".
Business Risk
Every company operates within a specific sector and operating environment. This operating environment includes the internal environment within the firm and the external environment output of the firm. The operating costs can be divided into fixed costs and variable costs.
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An increased percentage of fixed expenditures is detrimental to a firm. Due to its inability to lower fixed costs, such as a firm would see a higher than proportionate fall in operating profits if its total sales fell for whatever reason. It is stated that a company like this faces more business risk.
Financial Risk
Financial leverage, or the use of debt in the capital structure, determines financial risk. Because debt is a necessary component of the capital structure, interest payments are fixed and must be made regardless of the company's profitability.
The earnings per share that equity shareholders can access are more variable as a result of this fixed interest payment. For instance, EPS would rise if the operational profit ratio or rate of return exceeded the interest rate that must be paid on the debt. Conversely, EPS would be lower if the operating profit ratio was lower than the interest rate.
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In the case of a levered firm—a business with debt in its capital structure—the increase or decrease in EPS in reaction to changes in operating profit would be significantly greater than in the case of an unleveled firm. Financial risk is the fluctuation in EPS that results from having debt in a company's capital structure.
Difference Between Systematic Risk and Unsystematic Risk
- Systematic risk affects the entire market or the segment, while unsystematic risk refers to a specific industry, sector, or company.
- Systematic risk occurs due to external factors that are uncontrollable. Unsystematic risk arises due to internal factors and can be controlled.
- Systematic risk cannot be diverged through diversification, while unsystematic risk can be decreased or eliminated through diversification.
- Systematic risk measured by beta coefficient. Unsystematic risk measured by alpha coefficient.
- Systematic risk includes Inflation, recession, or interest rate risk. Unsystematic risk includes management issues or product recalls.
Advantages & Disadvantages of Unsystematic Risk
Advantages
- It is related to a specific company or industry and does not impact the overall economy. The risk can be controlled by the management of the firm.
- Using diversification of the portfolio or holding, one can easily avoid or mitigate the risk.
- Mainly, the risk arises due to internal factors. Hence, proper internal monitoring and analysis can help avoid or reduce the risk.
- The overall effect on the portfolio is less severe than the systematic risk and the scale of impact is quite lower than the systematic risk.
- In unsystematic risk, the number of people and the amount of money is low while in systematic risk, the number of people and the amount of funds are huge. Because it is related to the specific company or sector.
Disadvantages
- The risk can be effected on a particular company or industry and cause disruptions if the entire economy is going fine.
- Geopolitical crises can sometimes make it impossible to avoid the hazards, and their resolution takes a long period. While the product's prolonged unavailability reduces demand for it, investors and investors suffer from diminished production.
- At some point in time, an unquantifiable risk can cause a permanent shift in customer preferences. Such risks can have a significant impact on the market of a company or industry.
- Many employees and employers can be seriously impacted by the risks. The critical situation can affect the mood of the company. Whereas in the case of systemic risks, the situation can be managed due to the known difficulties.
- Policymakers must deploy a vast array of tools to address the issue. In some cases, the costs of action become prohibitively high in comparison to the issue.
- Since it doesn’t affect the economy and affects fewer people, government intervention is rare. As a result, it’s up to the private executives to solve the problem on their own. Furthermore, there’s little or no compensation or government assistance.
- This risk does not have a direct impact on the economy, but it does hurt the economy.
- The number of people involved with the risks is lower than the number of people involved in the systematic risks. As a result, the compensation is also lower or zero for the unsystematic risk. There is no government action in this risk category.
How to Measure Unsystematic Risk?
Unsystematic risk represents the beta coefficient of a company. The beta coefficient is simply a measure of the volatility of a stock in the stock market.
Now you can find the beta coefficient of each stock online such as Yahoo Finance. A lower beta stock is more volatile and vice-versa.
For instance, ITC Ltd's beta coefficient is 0.64, whereas the beta coefficient of Hindustan Unilever Ltd is 0.19.
Since the beta coefficient of Hindustan Unilever Ltd is lower, it means that it is less volatile, which means that you can invest more money in Hindustan Unilever and less money in ITC Ltd.
Calculation of Overall Beta
In a similar vein, the total beta of a portfolio can be determined. Suppose a portfolio consists of two stocks.
Total Beta = Percentage of total investment 1 x (Beta of investment 1) + Percentage of total investment 2 x (Beta of investment 2)
According to the above example of stock ITC and HUL, an investor has 70% in HUl and 30% in ITC.
Total Beta = (30% × 0.64) + (70% × 0.19)
= 0.192 + 0.133
= 0.325
Bottom Line
The dynamic nature of the unsystematic risk stems from the fact that each company or industry has its own unique set of challenges. The risk has no direct relation with the economy and the scale of impact is quite low. As a result, the government rarely intervenes, and private parties only need to deal with the problem. Therefore, an investor should diversify his portfolio to avoid severe shocks.
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