Unsystematic risk
Also written Company-specific risk · Diversifiable risk · Unique risk · Specific risk
The 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.
In plain language
If you have landed here looking for the risk that diversification cannot remove, you want systematic risk. This page is the other half of that pair.
Unsystematic risk is what can go wrong with one company. A labour strike at a factory. A promoter charged with fraud. A drug trial that fails. A bond issuer downgraded from AAA to AA+. None of it says anything about the economy; it says something about that one name.
And because it is specific, it can be diluted. Own forty companies instead of one, and a strike at any one of them is a small dent rather than a disaster. That is the entire economic function of a mutual fund's diversification.
How it works
The workbook draws the line in a single passage: company-specific risks, like a labour strike, impact individual firms and can be reduced through diversification; systematic risks, such as inflation, affect the entire economy and cannot be mitigated by diversification, making them non-diversifiable or market risks.
Total risk is the sum of the two:
Total risk = Systematic (market) risk + Unsystematic (company-specific) risk
Diversification shrinks the second term towards zero and leaves the first untouched. A fund manager can reduce unsystematic risk by diversifying across different companies but cannot avoid systematic risk except by staying out of the market — and SEBI regulations limit how much a scheme may hold in cash, so staying out is not really available either.
Then comes the sentence that makes this examinable rather than merely true. Finance theory suggests investors are rewarded only for taking non-diversifiable (systematic) risks. Unsystematic risk carries no expected reward, because anybody can diversify it away for free.
Which sets up the paradox at the heart of active management: to outperform the benchmark, a fund manager must take on some unsystematic risk by taking a view on individual securities. The only risk with no expected payoff is the only risk that can produce outperformance.
A worked example
Vikram holds Rs 10,00,000 in the shares of a single mid-cap auto components company.
The company's largest customer cancels a contract. The stock falls 28 percent in a week. Vikram is down Rs 2,80,000 — and the Nifty is flat, because nothing happened to the economy. That is unsystematic risk, undiluted.
Now put the same Rs 10,00,000 into a diversified equity scheme holding fifty stocks, of which this company is 1.8 percent of the portfolio.
Exposure to the company = 10,00,000 × 1.8% = Rs 18,000
Loss on the news = 18,000 × 28% = Rs 5,040
Rs 5,040 instead of Rs 2,80,000 — a 0.5 percent dent instead of a 28 percent one. The scheme did nothing clever; it simply owned forty-nine other things.
But watch the other direction. In March 2020 the whole market fell together. The diversified scheme fell with it, because no number of stocks protects against the market itself. Vikram's fifty holdings all dropped at once. That is systematic risk, and it is the one he is actually paid to bear.
Why NISM asks about it
Chapter 7.3 carries the heading "Difference between market / systematic risk and company specific risk", and the distinction is asked in almost every form: which risk diversification removes, which it cannot, and which one investors are compensated for. The related examinable idea is the one about active management — that a manager must accept unsystematic risk to beat the benchmark, which is why an index fund, which takes none, cannot outperform. Chapter 7 also gives the standard disclaimer, mutual fund investments are subject to market risks, and the reason it exists: diversification helps manage individual security risk but cannot eliminate broader market risk.
Common exam traps
- Unsystematic risk is diversifiable; systematic risk is not. Every question on this topic is a restatement of that sentence. Read carefully which one is being asked for.
- Investors are rewarded only for systematic risk. Taking more company-specific risk raises volatility without raising expected return — which is the argument against holding one stock.
- Beta measures systematic risk only. It says nothing at all about a portfolio's company-specific exposure, which is why the Treynor Ratio suits diversified portfolios and the Sharpe Ratio suits any portfolio.
- "Systemic risk" is a third, different word — the risk of the financial system itself failing. Do not read it as a synonym for systematic.
- Diversification is not free of limits. SEBI caps how much cash a scheme may hold, so a manager cannot simply exit the market to dodge systematic risk.
- Credit risk on one issuer is unsystematic; a general widening of credit spreads across the market is not.
Where this is taught
- Series V-B · Chapter 7: Performance of Mutual Fundsintroduced here
- Series XIX-B · Chapter 7: Category III AIF Investment Strategies and Due Diligence Processintroduced here
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series V-D · Chapter 10: Risk, Return and Performance of Fundsintroduced here
- Series X-A · Chapter 16: Portfolio Performance Measurement and Evaluationintroduced here
- Series SEBI-ICE · Chapter 5: Investment in Securities Marketintroduced here
- Series XVII · Chapter 5: Evaluating Fund Performance & Fund Selectionintroduced here
Related terms
- BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Sharpe ratioReturn earned above the risk-free rate divided by standard deviation — how much reward an investment produced for each unit of total risk its holder had to live with.
- Standard deviationA measure of how far returns typically stray from their own average — the standard statistic for total risk, counting company-specific and market-wide causes alike.
- 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.
- Treynor ratioRisk premium per unit of market risk — the return a scheme earned above the risk-free rate, divided by its beta rather than by its standard deviation.
- Systemic riskThe risk that one participant's default triggers defaults by others until the settlement system itself fails — the domino risk, not the market risk.
- Business riskThe variability of a firm's income flows caused by the nature of its business — driven by how volatile its sales are and how much of its cost base is fixed.