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What Is Unsystematic Risk?

by Shagun Saini
what is unsystematic risk

Here in this article, we will know about what is unsystematic risk? The formula for unsystematic risk and how can you calculate unsystematic risk? The sources of unsystematic risk as well as the factors affecting the unsystematic risk. We will also know about the systematic risk that can be avoided or naturally existing in the market while studying what is the difference between systematic and unsystematic risk? So, let us first understand what is unsystematic risk? By looking into the unsystematic risk definition and its meaning.

What Is Unsystematic Risk?

The unsystematic risk can also be referred to as specific risk, residual risk, or diversifiable risk, which is caused due to internal factors, and you cannot avoid or control it too. Although, you just can minimize it.

So, the unsystematic risk definition depicts the risk or danger which is present in the security or a portfolio of securities. This risk is not good for a company and is thus categorized as dangerous or hazardous for the company.

In contrast to unsystematic risk, there exists a systematic risk that can be avoided or naturally existing in the market.

The unsystematic risk arises from the factors which are within or inside the company and the company in all has no control over those factors as well. Even the company are not prepared as well as aware to take those internal factors causing unsystematic risk such as:

  • Labor strikes
  • Producing up non-desirable products
  • The inefficiency on account of the management
  • Having Defects in the business model
  • change in regulations of the company
  • The liquidity crisis in the company or the business
  • Changes in the capital structure

Graphical Representation Of Unsystematic Risk:

The unsystematic risk can also be presented graphically as follows:

what is the difference between systematic and unsystematic risk

Here, in this image, you can notice, on the y-axis, there exists total portfolio risk and on the x-axis, we have taken the number of stocks.

Where, the total risk as well as the unsystematic risk and the systematic risk. Where, the systematic risk is constant and remains with in the market, although the unsystematic risk fluctuates depending upon the market factors and is also not constant and non-avoidable as well.

The Formula For Unsystematic Risk

There exist 2 formulas for calculating the Unsystematic Risk:

  • Total Beta = Percentage of total investment 1 x (Beta of investment 1) + Percentage of total investment 2 x (Beta of investment 2)
  • Beta = Covariance / Variance

Example Of Unsystematic Risk

Thus, we can quote one example of unsystematic risk from many unsystematic risk examples. This risk cannot be avoided but diversified by investing. 

Example 1: As of 1st January 2021, you invested $ 2,00,000 in your portfolio, which is a diversified portfolio, and the investment of the diversified portfolio is as follows:

  • A – 15 %
  • B – 30 %
  • C – 5 %
  • D – 30 %
  • E – 15 %
  • F – 5 %

So, by now the total value of the portfolio will be a good figure as your risk is diversified by investing in different companies. Suppose your return of investment received on the portfolio is 13.6 % then your invested amount from $ 2,00,000 will now become $ 2,27,200. As the unsystematic risk is not correlated with the market risk giving the investor a fair chance to earn profit as well as invest by diversification of the portfolio.

Types Of Unsystematic Risk

There are primarily exist 3 types of unsystematic risks. Lets see what is unsystematic risk types as follows:

Now, we will discuss these risks in detail. 

  • The Business Risk Or Liquidity Risk

The business risk or Liquidity risk arises due to change in sales, income, profits, etc., or say due to fluctuations involved in the business. Therefore, it is also called Liquidity risk.

  • The Financial Risk Or Credit Risk

The financial risk or Credit risk is the result of financial changes or irregularities or methods adopted by the company. This may even involve short-term liquidity problems in the company.

  • Operational Risk

Operational risk occurs due to human error within the company and may also differ from industry to industry as well and from person to person too.

  • Insolvency Risk

Insolvency Risk is occurred by the company when the company or the firm is declared as insolvent. 

Sources Of Systematic Risk

There exist some factors such as macroeconomics factors that result in systematic risks, such as:

  • Interest Rate Risk

 Interest Rate Risk exists when the interest rate keeps on changing from time to time in the market. Where the interest rate also affects down the investments.

  • Market Risk

Market Risk is the change that is caused within the market while trading of stocks and securities due to which prices of instruments change in the market-leading to uncertainty.

  • Purchasing Power Risk

Purchasing Power Risk occurs when there is risk associated with the Purchasing Power of the company during the period of inflation or deflation.

What Is The Difference Between Systematic And Unsystematic Risk?

As, you know there exists both systematic and unsystematic risk in the market which together constitutes total risk. And there also exits difference between the two as one can be avoided and the other cannot. So, let us study the difference between systematic and unsystematic risk.

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Actions To Lessen The Unsystematic Risk:

You can lessen the business risk as well as the financial risk or say the unsystematic risk in all by following the ways as:

  • Classifying the risks
  • Analyse the risk impact on the company in all
  • Regularly monitor the tasks
  • Save enough of money 
  • Insure your business
  • Maximize your gains in the business
  • Attract shareholders to your company 

Frequently Asked Questions 

What Do You Mean By Unsystematic Risk?

The unsystematic risk can also be referred to as specific risk, residual risk, or diversifiable risk, which is caused due to internal factors, and you cannot avoid or control it too. Although, you just can minimize it. So, the unsystematic risk definition depicts the risk or danger which is present in the security or a portfolio of securities. This risk is not good for a company and is thus categorized as dangerous or hazardous for the company. The unsystematic risk arises from the factors which are within or inside the company and the company in all has no control over those factors as well.

What Is Unsystematic Risk Examples?

Some of the unsystematic risk examples includes internal sources of the company, change in regulations, entry of new competitor in the market, business as well as financial factors, etc. 

What Is The Difference Between Systematic And Unsystematic Risk?

As, you know there exists both systematic and unsystematic risk in the market which together constitutes total risk. And there also exits difference between the two as one can be avoided and the other cannot. So, let us study the difference between systematic and unsystematic risk.

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How Can You Prevent Unsystematic Risk?

The unsystematic risk can also be referred to as specific risk, residual risk, or diversifiable risk, which is caused due to internal factors, and you cannot avoid or control it too. Although, you just can minimize it. So, you can adopt diversification of portfolio to prevent unsystematic risk. The unsystematic risk arises from the factors which are within or inside the company and the company in all has no control over those factors as well.

Conclusion:

Thus, here we know more about what is unsystematic risk? The formula for unsystematic risk and how can you calculate unsystematic risk? The sources of unsystematic risk as well as the factors affecting the unsystematic risk. We will also know about the systematic risk that can be avoided or naturally existing in the market while studying what is the difference between systematic and unsystematic risk? As, the unsystematic risk can also be referred to as specific risk, residual risk, or diversifiable risk, which is caused due to internal factors, and you cannot avoid or control it too. 

Although, you just can minimize it. So, the unsystematic risk definition depicts the risk or danger which is present in the security or a portfolio of securities. This risk is not good for a company and is thus categorized as dangerous or hazardous for the company. The unsystematic risk arises from the factors which are within or inside the company and the company in all has no control over those factors as well. So, by now after reading the article we know what is unsystematic risk?

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