Sector-specific risk
Also written Sector risk
The risk tied to one industry, distinct from broad market risk. It is unsystematic, so it can be reduced by holding securities from other, unrelated sectors.
In plain language
Not every risk in an equity portfolio hits every stock the same way. Sector-specific risk is the part that hits only one industry — a regulatory change for pharma companies, a tariff for steel producers, a subsidy cut for renewable energy firms.
The workbook places it between two other risks. Market risk affects every listed stock, whatever its business, and cannot be diversified away. Company-specific risk affects one company alone, for reasons unique to that firm. Sector-specific risk sits in between. It does not touch the whole market, but it is not confined to a single company either.
How it works
Classification (Chapter 3, section 3.2.2). Sector-specific risks are non-systematic, so — like company-specific risk — they can be diversified away.
How the diversification works. The benefit comes from adding securities from other sectors that have low or negative correlation with the affected sector. A portfolio concentrated in one sector carries all of that sector's bad news; spreading holdings across sectors that do not move together dilutes it.
The workbook gives no numeric measure — no exposure limit, no correlation figure — for sector-specific risk itself. It states the mechanism, diversify across low- or negatively-correlated sectors, rather than a threshold.
A worked example
A PMS approach holds 60% of a ₹50,00,000 portfolio in IT services stocks, betting on strong export demand. A slowdown in client budgets hits IT services broadly: revenue guidance is cut across the sector, and the IT holdings fall 18% in a quarter, even though the overall market index is flat. That ₹30,00,000 IT allocation loses ₹5,40,000 — a loss that has nothing to do with company-specific mismanagement, and nothing to do with the broad market, which did not fall at all.
A second portfolio of the same size spreads its equity allocation across IT services, private banks, FMCG and pharmaceuticals — sectors that do not move in lockstep with IT export demand. When the same IT slowdown hits, only the IT slice, say 15% of the portfolio, is affected. The portfolio-level loss is a fraction of the concentrated portfolio's, for the same sector-specific shock.
Why NISM asks about it
Chapter 3 (Investing in Stocks), section 3.2, sets out three risks of equity investment in sequence: market risk (3.2.1), sector-specific risk (3.2.2) and company-specific risk (3.2.3). Expect a question asking a candidate to classify a described risk into one of the three, and to identify diversification as the tool for the last two but not the first.
Common exam traps
- Sector-specific risk is diversifiable; market risk is not. Confusing the two is the most common error in this three-way classification.
- Diversifying sector-specific risk means adding other sectors, not more securities within the same sector. More IT stocks does not reduce IT sector risk.
- Sector-specific risk is broader than company-specific risk. It can hit every company in the sector at once, good managers and bad alike.
- The workbook gives no numeric threshold for "enough" diversification here — treat this as a qualitative classification topic, not a calculation one.
Check yourself
1.According to the workbook, market risk:
- a)Can be diversified away completely
- b)Cannot be diversified away, though it can be hedged
- c)Neither can be diversified nor hedged
- d)Affects only one sector at a time
Show the answer
Answer: (b) Cannot be diversified away, though it can be hedged
"Market risk cannot be diversified away, though it can be hedged." Beta is its proxy measure.
Option A confuses it with company- and sector-specific risk. Option D describes sector-specific risk.
2.Systematic risk is:
- a)Company-specific and can be diversified away
- b)Market risk that cannot be diversified, measured by beta
- c)Measured only by semi-variance
- d)The reward earned as alpha
Show the answer
Answer: (b) Market risk that cannot be diversified, measured by beta
Systematic risk is market risk from common factors — interest rates, exchange rates, commodity prices. It cannot be diversified and is measured by beta.
Company- or sector-specific risk is unsystematic and diversifiable. The workbook says alpha is a reward for bearing unsystematic risk.
Where this is taught
Free preparation for NISM Series XXI-ARelated terms
- Market riskThe risk of loss from movements in market prices — one named category in a manager's risk framework, alongside credit, liquidity and operational risk, and the one measured with VaR and stress tests.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Unsystematic riskThe part of an investment's risk that belongs to one company or one issuer — a strike, a fraud, a downgrade — and which diversification can remove, unlike market-wide systematic risk.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Cross sectional diversificationHolding equities across different industries, sectors and geographies at a given time, so that sector- and company-specific risks offset. It cannot remove market risk.