💸principles of economics review

key term - Unsystematic Risk

Definition

Unsystematic risk, also known as diversifiable risk or idiosyncratic risk, is the component of an investment's total risk that is unique to that particular asset or investment. It is the risk that is specific to a company or industry and can be reduced or eliminated through diversification. Unsystematic risk is in contrast to systematic risk, which is the market-wide risk that cannot be diversified away.

5 Must Know Facts For Your Next Test

  1. Unsystematic risk can be reduced or eliminated through diversification, as it is specific to individual assets or investments.
  2. Examples of unsystematic risk include a company's management decisions, labor strikes, lawsuits, and changes in consumer preferences.
  3. Investors can minimize unsystematic risk by holding a well-diversified portfolio of investments across different industries and asset classes.
  4. The more diversified a portfolio is, the lower the unsystematic risk, as the unique risks of individual assets tend to cancel each other out.
  5. Unsystematic risk is an important consideration for investors when constructing and managing their investment portfolios.

Review Questions

  • Explain how unsystematic risk differs from systematic risk and how it can be managed through diversification.
    • Unsystematic risk is the risk that is specific to a particular asset or investment, such as a company's management decisions or industry-specific events. This type of risk can be reduced or eliminated through diversification, as the unique risks of individual assets tend to cancel each other out in a well-diversified portfolio. In contrast, systematic risk is the market-wide risk that cannot be diversified away, as it affects the entire market or economy. Investors can manage unsystematic risk by holding a variety of assets that are not perfectly correlated, thereby reducing the overall risk of their investment portfolio.
  • Describe the role of unsystematic risk in the context of how households supply financial capital.
    • When households supply financial capital, such as by investing in stocks, bonds, or other assets, they are exposed to both systematic and unsystematic risk. Unsystematic risk is particularly relevant in this context, as it represents the risk that is specific to the individual investments or assets within a household's portfolio. By diversifying their investments across different industries, asset classes, and companies, households can effectively manage and reduce their exposure to unsystematic risk, thereby improving the overall risk-return profile of their financial capital supply. Proper management of unsystematic risk is crucial for households to achieve their financial goals and objectives.
  • Analyze how the concept of unsystematic risk relates to the efficient allocation of financial capital by households.
    • The efficient allocation of financial capital by households is closely tied to the management of unsystematic risk. Households that understand the concept of unsystematic risk and its impact on their investments can make more informed decisions about how to allocate their financial capital. By diversifying their portfolios and minimizing their exposure to unsystematic risk, households can improve the risk-adjusted returns on their financial capital, leading to a more efficient allocation of resources. This, in turn, supports the overall functioning of the financial system and the broader economy, as households are able to supply their financial capital in a way that maximizes their risk-adjusted returns and supports the productive use of capital. The concept of unsystematic risk, therefore, is a critical consideration in the efficient allocation of financial capital by households.

"Unsystematic Risk" also found in: