Unsystematic Risk

Definition

Unsystematic risk, also known as diversifiable risk or unique risk, is the risk specific to an individual asset or investment that can be mitigated through diversification. It is the risk associated with a particular company or industry that is independent of the overall market movements.

5 Must Know Facts For Your Next Test

1. Unsystematic risk is specific to a particular company or industry and can be reduced through diversification, unlike systematic risk which affects the entire market.
2. Investors can mitigate unsystematic risk by holding a diversified portfolio of assets that are not perfectly correlated with each other.
3. Unsystematic risk includes factors such as management decisions, labor issues, regulatory changes, and competition, which can impact the performance of a specific company or industry.
4. The impact of unsystematic risk on a portfolio's overall risk can be reduced as the number of uncorrelated assets in the portfolio increases.
5. Unsystematic risk is more relevant for individual investors, as it can be diversified away, while systematic risk is more important for the market as a whole.

Review Questions

• Explain how unsystematic risk differs from systematic risk and how it can be managed through diversification.
  • Unsystematic risk is the risk specific to a particular company or industry, while systematic risk is the risk inherent to the entire market or market segment. Unsystematic risk can be mitigated through diversification, which involves investing in a variety of assets that are not perfectly correlated with each other. By holding a diversified portfolio, the impact of unsystematic risk on the overall portfolio risk can be reduced, as the losses from one asset may be offset by the gains from another. This is in contrast to systematic risk, which cannot be diversified away and affects all securities to some degree.
• Describe the role of unsystematic risk in the context of how households supply financial capital.
  • In the context of how households supply financial capital, unsystematic risk is an important consideration for individual investors. When households allocate their savings and investments, they must balance the trade-off between risk and return. Unsystematic risk, which is specific to individual companies or industries, can be reduced through diversification. By investing in a variety of assets, households can minimize the impact of unsystematic risk on their overall portfolio, while still seeking to maximize their returns. This allows households to more effectively supply financial capital to the market, as they can take on an appropriate level of risk based on their individual risk preferences and investment goals.
• Analyze how the concept of unsystematic risk relates to the efficient allocation of financial capital by households, and how it impacts their investment decisions.
  • The concept of unsystematic risk is crucial in the efficient allocation of financial capital by households. Households, as individual investors, must consider unsystematic risk when making investment decisions to supply financial capital to the market. By understanding that unsystematic risk can be diversified away, households can focus on investing in a variety of assets to reduce the overall risk of their portfolio, rather than trying to eliminate all risk. This allows them to take on an appropriate level of risk in pursuit of higher returns, ultimately leading to a more efficient allocation of financial capital. Furthermore, the ability to diversify away unsystematic risk empowers households to invest in riskier, but potentially higher-yielding, assets, as the impact of company-specific or industry-specific risks can be mitigated. This flexibility in investment decisions contributes to the overall efficiency of the financial system as households supply capital to the most productive uses.

Related terms

Systematic Risk: Systematic risk, also called market risk, is the risk inherent to the entire market or market segment. It is the risk that cannot be diversified away and affects all securities to some degree.

Diversification: Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. It is a risk management strategy that aims to mitigate unsystematic risk by investing in a variety of assets.

Portfolio Risk: Portfolio risk is the overall risk associated with an investment portfolio, which is a combination of systematic risk and unsystematic risk. Diversification can reduce the portfolio's overall risk by lowering the impact of unsystematic risk.