Unsystematic Risk

What Is Unsystematic Risk?

Unsystematic risk is the part of an investment's total risk that comes from factors specific to one company or a small group of companies. Examples include a product recall, a failed drug trial, a labor strike, a fraud scandal, or the departure of a key executive. Because these events relate to a particular business rather than the whole economy, this risk is also called company-specific risk or idiosyncratic risk.

How It Works

Total risk in a portfolio can be split into two parts. Systematic risk is the market-wide portion, driven by things like interest rate changes, recessions, or major political events. It affects nearly all assets to some degree and cannot be removed by diversifying. Unsystematic risk is the remainder, and it is specific to each holding. One company's shares may fall for internal reasons while others rise, so these risks can offset each other when combined.

This is why diversification is the main tool for managing unsystematic risk. Holding investments across different companies, industries, and countries means a bad outcome for one holding has a smaller effect on the overall portfolio. The idea is central to modern portfolio theory.

Consider an investor who owns shares in only one airline. If the company faces a major safety investigation, its shares could drop sharply while most other sectors are unaffected. An investor who also owned companies in unrelated industries would feel a much smaller impact from that single event.

Why It Matters to Investors

Financial theory generally holds that investors are not rewarded with extra expected return for bearing unsystematic risk, because it can be eliminated through diversification. Systematic risk cannot be diversified away, and models such as the capital asset pricing model assume that only this type of risk is priced into expected returns.

A concentrated position in a single stock therefore carries a large amount of unsystematic risk. If that company runs into trouble, the loss can be severe even when the broader market is doing well. Understanding this distinction helps investors see why spreading holdings across many assets is commonly used to reduce exposure to events that affect only one business.