Definition and Examples of Unsystematic Risk
Unsystematic risk refers to any type of risk that is specifically associated with investing in a particular company or industry. Unsystematic risk can be reduced through diversification in your portfolio. Sources of unsystematic risk include business risk and financial risk. The total risk of an investment portfolio consists of unsystematic risk and systematic risk – the latter affects all companies in a particular market.
How Does Unsystematic Risk Work?
Unsystematic risk, along with systematic risk, is part of the total risk of an investment portfolio. Systematic risk refers to risks that impact all companies in the market. Unlike systematic risk, unsystematic risk can be minimized through specific diversification. To reduce unsystematic risk through diversification, you should create a portfolio of securities whose returns are not negatively correlated. These changes offset each other, reducing the overall variation in portfolio returns from one period to the next. A well-diversified portfolio may also provide protection against financial crises, as risks will be mitigated.
What Does This Mean for Individual Investors?
Individual investors can reduce the overall investment risk by investing in securities whose returns are not correlated with each other, as this reduces unsystematic risk. Reducing unsystematic risk can decrease the variability in your portfolio returns. Since unsystematic risk can be reduced through diversification, while systematic risk cannot, this means that an individual investor cannot completely eliminate risk and must still be willing to accept some level of risk if they wish to invest. Investors should understand how their investments are exposed to different types of risk, as well as the total level of risk they are bearing in their portfolios. They should be aware of how these risks affect their willingness to take on risk and their ability to achieve financial goals. If you have concerns about your investment strategy and the associated risks, consider consulting a financial advisor.
Source: https://www.thebalancemoney.com/what-is-unsystematic-risk-5204823
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