Unsystematic risk

Definition

Unsystematic risk refers to the risk associated with a specific asset or investment, which can be eliminated through diversification. This type of risk is unique to a particular company or industry and is not correlated with market-wide risks, meaning it does not affect the overall market. Understanding unsystematic risk is crucial for effective risk assessment and management strategies, as well as for evaluating asset pricing and making informed decisions based on risk-return tradeoffs.

5 Must Know Facts For Your Next Test

1. Unsystematic risk can arise from factors like management decisions, product recalls, or changes in consumer preferences that impact a specific company.
2. Investors can reduce unsystematic risk by holding a well-diversified portfolio of different assets across various industries.
3. Unlike systematic risk, which affects all securities in the market, unsystematic risk can be controlled and minimized through strategic investment choices.
4. The importance of understanding unsystematic risk lies in its ability to influence individual asset performance without affecting the broader market.
5. In terms of asset pricing, higher unsystematic risk may lead investors to demand higher returns for holding those specific assets.

Review Questions

• How does unsystematic risk differ from systematic risk in terms of its impact on investment portfolios?
  • Unsystematic risk is specific to individual assets or companies and can be mitigated through diversification, meaning that it does not affect the entire portfolio if managed properly. In contrast, systematic risk impacts the whole market and cannot be diversified away. This fundamental difference influences how investors approach their portfolios, as they can actively reduce unsystematic risks but must accept exposure to systematic risks.
• Discuss how diversification serves as a strategy for managing unsystematic risk within an investment portfolio.
  • Diversification is a key strategy for managing unsystematic risk as it involves spreading investments across various assets, sectors, or geographies to limit exposure to any single asset's risks. By including a mix of different investments that are not correlated with each other, an investor can significantly reduce the potential negative impact of any one asset's poor performance on their overall portfolio. This approach helps stabilize returns and lowers the overall volatility of the investment.
• Evaluate the significance of understanding unsystematic risk in making informed investment decisions regarding asset pricing and return expectations.
  • Understanding unsystematic risk is vital for investors as it directly influences their expectations for asset pricing and required returns. Investors need to recognize how unique risks associated with particular companies or sectors can impact potential returns. By evaluating these risks alongside systematic factors, investors can make better decisions about their portfolios, adjusting their expectations for returns based on the level of unsystematic risk they are willing to accept. This comprehension allows for more strategic planning in investment choices and enhances overall portfolio performance.

Related terms

Systematic Risk: Systematic risk is the risk inherent to the entire market or market segment, which cannot be eliminated through diversification. It is influenced by factors such as economic changes, political events, and natural disasters.

Diversification: Diversification is an investment strategy that involves spreading investments across various assets to reduce exposure to any single asset's unsystematic risk.

Capital Asset Pricing Model (CAPM):

CAPM is a financial model used to determine the expected return on an asset based on its systematic risk, measured by beta, and the expected market return.