06 Jun What is Unsystematic Risk?
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A company’s stock price may fall due to factors that are specific to the industry that it operates in. The reduction in share value may also be due to poor management practices within the company. These are referred to as unsystematic risks. They relate to company-specific or industry-specific issues and not to the wider market.
Unsystematic risks are also known as diversifiable or non-systematic risks. They affect a single company or an industry.
What does unsystematic risk mean?
Say, for example that you invest in the stock of a gold mining company. Soon after you make your purchase, the price of gold falls from $1,330 per ounce to $1,100 per ounce. As a result of this, it is likely that the share price of the company will see a sharp reduction.
Consider another scenario. After you buy the shares of a gold mining company, the price of gold rises by 20%. But there is an explosion in the company’s largest mine and it is shut down. Restarting the mine is expected to take 18 months. Again, the stock price is likely to nosedive.
Both the situations described above represent unsystematic risks. This type of risk has the following characteristics:
⇨ It affects a company or an industry.
⇨ It is controllable. An investor can manage this risk by diversification.
A company may face an unsystematic risk in the form of changed government regulations that adversely affect its performance. For example, a chemical company may need to install expensive equipment to reduce its toxic emissions. A competitor operating in another country may not need to incur any expenditure on this account.
Unsystematic risk may also result from a product recall or a fraud by an employee.
In recent years, e-commerce firms have made rapid strides in increasing their market share. Amazon sold goods worth about $180 billion in the U.S. in 2017. A large part of these sales have come at the cost of brick and mortar companies. Traditional retailers with their high cost structures are simply unable to compete.
Example of unsystematic risk
Sears Holdings, the firm that owns the Sears and Kmart store brands has been finding it very difficult to compete with Amazon on prices. It has been closing stores and laying off its employees.
What effect has the competition from Amazon and other e-commerce firms had on Sears’ stock price? Share valuations have dropped by almost 70% in the last one year.
If you had bought Sears stock a year ago, you would have lost a large part of your investment due to an unsystematic risk.
Unsystematic risks pertain to a company or an industry. They are controllable because you can diversify your investment holdings by buying stocks in companies that operate in unrelated industries.