Unsystematic risk, also known as specific risk, is the risk that is specific to a company or an industry. This is a risk that investors and, therefore can easily minimize, is also known as diversifiable risk.
Unsystematic risk does not affect every business; its impact is unique to every company or industry it relates to. It exists due to internal factors of the company or the industry rather than external factors.
As unsystematic risk relates to only a specific company or industry, investors can easily minimize this risk by diversifying the portfolio of their investments.
For example, investor-only holding shares of Apple Inc. or shares of companies in the smartphone industry can simply minimize unsystematic risk by buying shares of other companies in other industries.
Since unsystematic risk exists due to internal factors of a company or the industry, it can easily be managed and controlled by the company.
For example, any fluctuations that arise in the company’s earnings can be easily controlled by the management by identifying the source of these fluctuations and controlling them.
Furthermore, unsystematic risks can be controlled much quicker than systematic risk.
Although unsystematic risks are easily controlled and can be resolved at a quicker pace, they are not predictable.
These risks may occur at any unspecific time and cause disruption. In the example above, while the company can identify a fluctuation in earnings and its source, the company cannot forecast such an event. This is why unsystematic risks always exist.
As the name suggests, unsystematic risk is the opposite of systematic risk. Systematic risk is the risk that relates to a market or market segment as a whole.
Unlike unsystematic risk, systematic risk cannot be diversified by investors owning a diversified portfolio.
For example, a stock market crash will affect the stocks of all the companies regardless of how diversified an investor’s portfolio may be.
Systematic risk is a risk that, contrasting to unsystematic risk, exists due to external factors outside the control of a company.
It might include economic, political, technological, social, legislative, or ecological factors. For example, the United States restricting business with China affected many companies that sourced their production in China.
Categories of Unsystematic Risk
Unsystematic risk generally falls into two broad categories, these are:
Business risk is a category of unsystematic risk related to a company’s internal or external factors. It relates to the nature of the business and the daily operations of the business.
Risks that affect a business’s ability to generate revenues, control its expenses, and generate earnings are all examples of business risk.
Financial risk is the category of unsystematic risk that deals with how a company funds its operations and how the company uses those funds.
Financial risk relates to the company’s capital structure rather than its financial activities.
Determining Unsystematic Business Risk
To determine the unsystematic business risks, it is important to know the types of these risks. The types of unsystematic business risks include:
One of types of business unsystematic risks that a company faces is operational risk. Operational risk is the risk that a company’s inadequate or failed processes may result in an operational loss for the company.
It is a risk that a business faces in its daily operations. It mainly relates to the processes that a company uses to generate revenues.
Operational risks may exist due to small reasons such as a human error by an employee disrupting the daily operations or due to bigger reasons such as a system failure.
Any fraudulent or deceitful activities also fall under operational risk. Generally, any risk associated with disrupting a company’s business processes is the company’s operational risk.
Every business has strategies for all aspects of its operations. Strategies can be high level, known as corporate strategy, medium level, known as a business strategy, or low level, known as functional strategy.
Strategic risk is the type of unsystematic business risk that relates to the wrong strategy being followed by the business.
It is the risk that influences the worth of the business the most.
Strategic risk is generally caused by the top-level management of a company, mainly the directors. This is because the directors carry out all strategic decision-making.
A wrong strategy can affect the ability of the business to generate revenues both in the long-term and in the short-term.
For example, if a new strategic decision by directors to target a new market segment fails, the revenue generation ability of the business will be significantly affected.
As businesses grow, they develop a reputation or a goodwill in the market which increases the revenues generated for the business.
Reputational risk is the risk that a business does something to damage the goodwill or reputation it has developed for itself in the market.
For example, with the launch of the Samsung Note 7, Samsung lost its reputation because it failed to properly adhere to safety procedures of the phone.
Businesses need to comply with many rules and regulations set by the environment they operate in. A business faces compliance risk if it fails to comply with these rules and regulations.
These risks result in fines or legal actions against the business. If a business wants to succeed in the long run, it must identify and comply with all the regulations it is bound by.
Innovation risk generally applies to industries where constant innovation is important such as the smartphone industry or the fashion industry.
It is the risk that a business cannot keep up with the innovations of the market or does not come up with innovations to boost its revenues and earnings. Aside from these industries, this risk may also apply to other industries such as the vehicles industry.
Apart from these major types of unsystematic business risks, there are other types as well. These risks have smaller effects or don’t apply to a wide range of businesses as compared to the above.
These types might include but are not limited to, Legal risk, Quality risk, Credit risk, Process risk, Political Risk, Economic Risk, Competitive risk, etc.
Unsystematic risk is the type of risk that is specific to a certain business or industry. The opposite of unsystematic risk is systematic risk which applies to a whole market or market segment.
Unsystematic risk falls into two categories known as business risk and financial risk. It is important to determine the type of business risk to determine the unsystematic business risk.