Unsystematic risk

Definition

Unsystematic risk refers to the specific risks associated with an individual asset or a small group of assets, which can be reduced or eliminated through diversification. Unlike systematic risk, which affects the entire market, unsystematic risk is unique to particular companies or industries. It encompasses factors like management decisions, product recalls, or regulatory changes that can impact a company's performance without influencing the broader market.

5 Must Know Facts For Your Next Test

1. Unsystematic risk can be mitigated by holding a diversified portfolio, as the negative impact of one asset can be offset by the performance of others.
2. Examples of unsystematic risk include risks related to a company's management, financial health, or competitive position in its industry.
3. Investors are typically compensated for taking on systematic risk through higher expected returns, while unsystematic risk does not command additional returns once diversification is considered.
4. The concept of unsystematic risk is crucial in capital budgeting and investment decisions, where understanding specific asset risks can influence project evaluations.
5. Unsystematic risk is often referred to as idiosyncratic risk or specific risk and is distinct from broader market risks that cannot be eliminated through diversification.

Review Questions

• How does unsystematic risk impact an investor's decision-making process when constructing a portfolio?
  • Unsystematic risk influences an investor's approach to portfolio construction by highlighting the importance of diversification. Investors seek to reduce unsystematic risk by including a variety of assets from different sectors and industries in their portfolios. By doing this, they can minimize the potential negative impact of any single asset's poor performance on their overall returns. This understanding helps investors balance their portfolios more effectively and manage their overall risk exposure.
• Discuss the relationship between unsystematic risk and capital budgeting decisions when evaluating potential investments.
  • In capital budgeting, understanding unsystematic risk is essential for accurately assessing potential investments. Decision-makers must consider specific risks associated with each investment opportunity, such as operational challenges or market competition. By analyzing these unique risks, they can make more informed evaluations and forecasts about cash flows and profitability. This approach ensures that projects are not only selected based on projected returns but also on their ability to manage and mitigate specific risks associated with them.
• Evaluate how the concepts of unsystematic and systematic risk together influence the cost of capital for businesses.
  • The interplay between unsystematic and systematic risk significantly shapes a company's cost of capital. While systematic risk affects all firms within the market, unsystematic risk is unique to individual firms. Investors demand a higher return for bearing systematic risk since it cannot be eliminated through diversification. However, if a company successfully mitigates its unsystematic risks through strategic management and diversification, it may lower its overall perceived risk and therefore its cost of capital. Understanding these dynamics helps businesses align their financing strategies with their operational realities and market conditions.

Related terms

systematic risk: Systematic risk is the inherent risk that affects the entire market or a large segment of the market, such as changes in interest rates, inflation, or geopolitical events.

diversification: Diversification is an investment strategy that involves spreading investments across various assets to reduce exposure to any single asset's risk.

beta: Beta is a measure of an asset's volatility in relation to the overall market, indicating how much the asset's price is expected to change in response to market movements.