Unsystematic Risk

Unsystematic Risk: Definition, Types, and How to Manage It

What is unsystematic risk?

Unsystematic risk (also called idiosyncratic or diversifiable risk) is the risk that affects a single company or a specific industry rather than the entire market. These are events or conditions unique to one firm or sector—examples include management failure, a product recall, a lawsuit, or a supply-chain disruption. Because these risks are specific, they can largely be reduced or eliminated through diversification.

How it works

Total investment risk = systematic risk + unsystematic risk.

• Systematic risk (market risk) affects the whole market—examples: recessions, interest-rate changes, inflation.
• Unsystematic risk affects only particular companies or industries.
• By holding a sufficiently diversified portfolio across companies, sectors, and asset classes, an investor can substantially reduce unsystematic risk. Systematic risk, however, cannot be fully diversified away.

Common types of unsystematic risk

• Business risk: Operational or strategic problems that reduce a company’s competitiveness or profitability (e.g., failed product launch, construction delays).
• Financial risk: Risks tied to a company’s capital structure and ability to meet obligations (e.g., excessive debt, liquidity shortfalls).
• Operational risk: Failures in day-to-day processes or systems (e.g., supply-chain breakdowns, production accidents, cybersecurity breaches).
• Strategic risk: Poor strategic choices or failure to adapt to market changes (e.g., entering a declining market, missing a major industry shift).
• Legal and regulatory risk: Adverse changes in laws or regulations, regulatory bans, or costly litigation.

Examples

• An airline facing a pilots’ strike or safety-related grounding—a problem concentrated in the airline industry.
• A pharmaceutical company losing FDA approval for a drug or facing a major recall.
• A tech firm suffering a major data breach exposing customer information.
  These events can sharply reduce the value of affected companies while leaving unrelated sectors relatively unscathed.

Measuring unsystematic risk

Unsystematic risk is not directly observable with a single metric like beta (which measures systematic risk). One common way to estimate it:
– Unsystematic variance = Total variance − Systematic variance
Beta is used to quantify systematic (market) volatility; the remainder of total variance is treated as idiosyncratic or unsystematic.

How to reduce unsystematic risk

• Diversify across many companies and industries.
• Hold uncorrelated asset classes (e.g., bonds, real assets) alongside equities.
• Use asset allocation to balance exposure to market-wide (systematic) factors.
• Monitor company fundamentals and adjust holdings as needed to avoid concentrated exposures.

Explain it simply

Unsystematic risk is like putting all your eggs in one basket: if that basket gets dropped, only those eggs break. Spreading your eggs across many baskets keeps one accident from ruining everything.

Quick FAQs

• Can unsystematic risk be eliminated? Mostly—sufficient diversification can remove the bulk of it, though perfect elimination is theoretical.
• How is it different from systematic risk? Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is company- or industry-specific and is diversifiable.
• What practical steps reduce it? Diversify holdings across sectors and asset classes and avoid concentrated bets.

Bottom line

Unsystematic risk is the company- or industry-specific portion of investment risk. It can be substantially reduced through diversification and prudent portfolio construction. Investors should focus on both removing idiosyncratic exposures and managing unavoidable market-level risks through appropriate asset allocation.