Unsystematic risk is a concept in finance and portfolio theory that refers to the extent to which a company’s stock return is uncorrelated with the return of the overall stock market. This type of risk may be thought of as industry-specific or company-specific risk. It is the opposite of systematic risk, which is that risk inherent to an entire market.
It is commonly referred to as specific or idiosyncratic risk, since unsystematic risk affects only a relatively few firms rather than the overall market. For example, the risk of food poisoning is unsystematic risk, since it applies only to firms handling human food. Key man risk is also unsystematic, since few individual companies are likely to suffer a large drop in value if their leaders were to suffer unexpected incapacitation.
The unsystematic risk inherent in individual stocks is routinely quantified by professional investors using statistical regression analysis. Like all forms of risk, it is measured as the volatility of returns, with returns including both stock, or share, price appreciation and dividends.
From the point of view of an investor, all risk is a negative. Some risk is less negative than others, however, and detracts less from the value of an asset. Unsystematic risk is preferable to systematic risk since its negative effect can be removed within the context of an overall portfolio. As a result, unsystematic risk is also known as diversifiable risk.
The concept of unsystematic and systematic risk is very helpful for investors seeking to construct a large, diversified investment portfolio that mirrors the overall market. If constructed well, that portfolio will closely track the market. If the market increases in value, the portfolio will also increase in value by the same percentage. If the overall market decreases in value, the portfolio will also go down.
Adding a stock that is uncorrelated with the overall market to a portfolio will tend to decrease the volatility of that portfolio’s return. To that extent, the portfolio is said to become more efficient. The unsystematic risk of the individual stock is removed through the diversification inherent in the overall portfolio.
The investment market does not reward investors for carrying unsystematic risk — it does not allow investors to be compensated for incurring the specific risk inherent in an individual stock. Competition in the investment market drives down the price of a stock to a level that eliminates any compensation for this risk. Efficient investors neutralize the negative impact of unsystematic risk through efficient portfolio diversification.