Meaning
Unsystematic risk refers to factors that can cause a company's or a sector's stock price to move independently of the overall market. This can include management decisions, product issues, competitive pressures, regulatory changes, or other company-specific events. It is distinct from market risk, or systematic risk, which affects almost all assets.
How it is used
In portfolio design, unsystematic risk is the portion of risk that diversification targets reducing. By spreading investments across different companies and industries, the impact of a single adverse event is lessened across the portfolio. The degree of reduction depends on how the holdings are correlated; more diversification across uncorrelated assets yields larger reductions.
Diversification impact
Diversification does not eliminate all risk. Even with broad diversification, a portfolio still faces systematic risk tied to the overall economy and markets. The residual unsystematic risk tends to shrink as the number of independent holdings grows, but correlations among assets can limit how much risk can be removed.
Context
Unsystematic risk is a key consideration in talks about asset allocation, risk budgeting, and the construction of stock-screening rules. It is also relevant when evaluating how specific events might affect different parts of a portfolio.
For instance, a portfolio that includes several firms across industries may experience less impact from a single company's earnings surprise than a single-stock investment.
Diversification · Systematic risk · Idiosyncratic risk · Beta · Portfolio risk · Capital Asset Pricing Model · Asset allocation