What is unsystematic risk?

Unsystematic risk is a concept in finance and portfolio theory that refers to the extent to which a company's stock performance is not correlated with the performance of the broader stock market. This type of risk can be considered as an industry or company specific risk. It is the opposite of systematic risk, which is that risk inherent to an entire market.

It is commonly known as specific or idiosyncratic risk, as unsystematic risk affects only a few companies and not the market as a whole. For example, the risk of food poisoning is an unsystematic risk as it only applies to companies that handle human food. Key man risk is also unsystematic, as few individual companies are likely to experience a large drop in value if their leaders suffer an unexpected disability.

The unsystematic risk inherent in individual stocks is routinely quantified by professional investors using statistical regression analysis. Like all forms of risk, it is measured as the volatility of returns, with returns including equities as well as price appreciation and dividends.

From an investor's point of view, all risk is negative. However, some risks are less negative than others and less damaging to the value of an asset. Unsystematic risk is preferable to systematic risk as its negative effect can be eliminated in the context of an overall portfolio. As a result, unsystematic risk is also known as diversifiable risk.

The concept of systematic and unsystematic risk is very useful for investors who want to build a broad and diversified investment portfolio that reflects the general market. If well built, this portfolio will closely follow the market. If the market increases in value, the portfolio will also increase in value by the same percentage. If the overall market value goes down, so does the portfolio.

Adding a stock that is uncorrelated to the broader market to a portfolio will tend to decrease the volatility of that portfolio's return. In this sense, it is said that the portfolio becomes more efficient. The unsystematic risk of individual stocks is eliminated through the diversification inherent in the overall portfolio.

The investment market does not reward investors for taking unsystematic risks, it does not allow investors to be compensated for incurring the specific risk inherent in an individual stock. Competition in the investment market reduces the price of a stock to a level that eliminates any compensation for that risk. Efficient investors counteract the negative impact of unsystematic risk through efficient portfolio diversification.

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