Unsystematic risk is the flip side of the two primary risks investors face. The other risk is called systematic risk. Understanding the difference between these two risks means understanding why some risks can’t be reduced/eliminated from a portfolio while other risks can.
Diversification is often the go-to strategy for reducing portfolio risk. While diversification can reduce some risks, it can’t reduce all risks. Read further to see why.
Unsystematic Vs. Systematic Risk
Unsystematic risk is also called idiosyncratic or company-specific risk. This is a risk inherent to a company rather than the broader market. For example, a company can experience an adverse event that causes its stock to drop while the overall market is moving up.
Systematic risk means the same company can be doing well but have its stock drop because the overall market is dropping. Even though the company is doing well and under normal conditions would probably see its stock rise because overall sentiment has changed, and the company experiences systematic or market risk.
Investors have tools available to deal with unsystematic risk. However, there isn’t anything investors can do to manage systematic risk. Systematic risk is always present in virtually every investment. U.S. government bonds, savings accounts, and CDs may be said not to have any systematic risk because the government virtually guarantees the return of principal.
Real estate, stocks, and corporate bonds do not have any guarantees on the return of principal. Events in the overall market can cause these investments to lose some or all of their value.
Diversification and Unsystematic
Unsystematic risk occurs when a company files for bankruptcy, launches a product that fails in the marketplace, or takes on a project with large cost overruns. All can cause the company's value to decrease, adversely affecting investors.
Investors can manage unsystematic risk by not investing in risky companies and diversifying their portfolios. Diversification doesn't just mean adding more stocks to a portfolio. These stocks need to be uncorrelated. Meaning, that stock prices do not move together, and the companies are in different sectors.
The above is an example of portfolio diversification and doesn't remove the possibility that some company experiences a negative event that causes their stock price to drop. Instead, diversification limits the impact of one stock on the entire portfolio.
Let's say an investor has 30 stocks in their portfolio. One of the investor's holdings announces a major recall for its product. The stock plummets on the news. Because the investor is holding close to equal weightings of all companies, the single stock doesn't cause the portfolio's value to plummet with it. Instead, the portfolio sees only a small change in its value. While one stock is dropping, others are rising.
Can unsystematic risk be eliminated? The only way to eliminate unsystematic risk is to not invest. It's difficult to foresee when a company might experience an adverse event and then anticipate what the market's reaction will be to it. So no, investors cannot eliminate unsystematic risk. But investors can manage it through diversification.
