Unsystematic Risk

The stock market is risky. There are two main types of risk: systematic risk and unsystematic risk. Knowing what these risks are is important for making smart investment choices. This article will explain unsystematic risk, its different kinds, and how it relates to systematic risk.  

What is Unsystematic Risk?

Unsystematic risk entails uncertainties about a specific investment in a company or industry. Some examples are the entry of a new competitor in the market that will consume the substantial market share of the invested company, the effects of sales via changes in regulations, management changes, or product recalls.

Although the investor may foresee some sources of unsystematic risk, it is hardly possible that any potential risk may be predicted. For instance, an investor in Indian pharmaceutical stocks may foresee the change in regulation but may be grossly unaware of the implications of new regulations and how these regulations will impact companies and customers.

More examples of unsystematic risks are strikes by workers and legal settlements. This risk is also known as diversifiable risk since it can be curbed through proper portfolio diversification. Knowing the meaning of unsystematic risk can help you evaluate stocks when major news about a company’s operation hits the market.

Types of Unsystematic Risk

The different types of unsystematic risk that can arise with companies due to their internal issues with business operations are:

Business Risk

Business risk can originate from both internal and external factors. Internal risks deal with operational efficiencies. For instance, if a company like Sudarshan Chemical Industries doesn't continue to look for new technologies or protect its proprietary technologies, it could lose its competitive edge.

One such example of entrepreneurial risks is the ban by RBI on Paytm Payments Bank in 2020 for onboarding new customers. The ban was because of concerns regarding its regulatory provisions. This drastically affected the business operations of Paytm Payments Bank.

Financial Risk

Financial risk has to do with the capital structure of a company. A company must balance debt and equity to ensure growth and meet financial obligations. For example, the case of the Yes Bank's economic crisis in 2020 really set a clear example of how weak capital and high levels of bad debts can lead to severe financial instability. All this resulted from the poor management of nonperforming assets and the high level of leverage.

Operational Risk

Operational risks arise from adverse or careless events such as supply chain disruption or serious errors in the production process. For example, manufacturing defects in the Nanocar caused Tata Motors to face delays and cost escalation, further impacting its profitability and operational efficiency.

Operational risk can also be considered in the light of business continuity and system or policy failure on a day-to-day basis. For instance, ICICI Bank's information technology systems went down in 2022, disrupting banking services and inconveniencing customers.

Strategic Risk

Strategic risk occurs when the company remains in a shrinking industry or has poor strategic moves. For instance, when Reliance Jio entered the Indian telecom market in 2016, it resulted in a significant change in competitiveness. The old incumbent firms, such as Bharti Airtel, needed to alter their move as the Jio pricing was too aggressive or highly competitive to adopt and appeared to grow too fast.

Legal and Regulatory Risk

Legal and regulatory risk is the risk that a business will incur losses after adverse effects brought about by changes in laws or legal provisions. For example, Uber's business operations were heavily hampered in India due to legal battles between the company and regulators over the licensing process and operational restrictions.

How to Measure Unsystematic Risk

The measure of unsystematic risk in stock investments is called the unsystematic variance, which is simply finding the difference between the systematic and total variances.

Difference Between Systematic and Unsystematic Risk

Systematic risk is something that cannot be diversified away, and that affects the market as a whole, like risks from changes in the economic conditions of a country or an increase/decrease in interest rates. Unsystematic risk can usually be diversified away and affects companies or individual industries.

Mitigating Unsystematic Risk with Portfolio Diversification

There are also ways to manage these risks, systematic and unsystematic. One significant way of reducing these risks is asset allocation, which spreads the risk across multiple assets in different sectors. Instead of investing all your money in a single company stock, you distribute the investment, thus effectively managing the overall risk.

For example, consider an investor who has invested in the Indian airline industry, such as SpiceJet or IndiGo, who would face high levels of unsystematic risk. He stands to lose significantly if the sector were to face a downturn, be it due to widespread labour strikes or changes in government regulation. His portfolio would be affected just by hearing such news.

This can be avoided by diversifying your portfolio in several sectors, such as technology (e.g. Infosys) or pharmaceutical ones (like Sun Pharma), and investing in government bonds to drop risks from particular industries.

The unsystematic risk would harm individual firms and the respective sectors. For instance, labour problems developed within the airline sector would also cause harm to industries relevant to this sector, such as firms supplying fuels or travel service providers. Diversification spreads the risk across a wide variety of assets, including the U.S. These can include treasury bonds or other stable investments that help reduce the impact of fluctuations in stock prices.

Even with diversification, a portfolio cannot eliminate all types of risks. Some systematic risks will still remain because they include wide-ranging uncertainties such as changes in interest rates, economic downturns, financial crises, or natural disasters.

Conclusion

Risks related to business operations, financial management, regulatory changes, and business strategy affect the specific company or industry. It will not have a widespread effect on the overall stock market. Thus, unsystematic risk is diversifiable, meaning that investors can reduce this risk by holding stocks of various companies in different industries. By constructing a well-diversified portfolio, investors avoid the individual company and industry-level specific risks.
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