Everything You Need to Know About Unsystematic Risk is Right Here

There are several concepts revolving around unsystematic risk management. This article is your go-to guide that explains all that you need to know  about unsystematic risk, in a very comprehensive manner.

What is An Unsystematic Risk?

Just like the question, the answer also is simple since the unsystematic risk is associated with the internal risk factors of the firm. Unsystematic risk is also known as specific risk, diversifiable risk, idiosyncratic risk or residual risk. An unsystematic risk arises from any such event the business is not prepared for and which disrupts the normal functioning of the business.

For instance, a firm may generate high profits in case of which the stock prices go up. On the other hand, some other firm may generate low profits which make its stock prices go down.

Some of the factors leading to unsystematic risk include:

• The inefficiency of the management
• Flaws in the business model
• Liquidity crunch in the business
• Changes in the capital structure
• Production of non-desirable products
• Labor strikes

Unsystematic risk is diversifiable in nature and thus, can be avoided. It is a fact that you can diversify your portfolio by buying shares of different companies and also in different geographical locations. This way, even if some businesses that you have invested in face adversity because of unsystematic risk, not all businesses will. Hence, the unsystematic risk which is unique to one or a couple of stocks gets avoided.

Below, you can see the graph explaining unsystematic risk.

Source: CFI

In the graph, we have taken the total portfolio risk on the Y-axis and number of stocks on the X-axis. It is clearly visible in the graph that an unsystematic risk is more in case you do not have a diversified portfolio. But, as you start investing in more than one stocks, your unsystematic risk goes down and approaches zero.

Nevertheless, systematic risk depends on various macroeconomic factors such as interest rate hike and inflation which can not be avoided. Recently, we can take the outbreak of the coronavirus pandemic as an example. It affected the entire financial ecosystem and the financial markets suffered great losses. We will discuss the definition of unsystematic risk now to make it clear in brief what this type of risk implies.

Going forward, let’s look at an example.

Example of Unsystematic Risk

Let us assume that on 1st January 2019, you invested $100,000 in your portfolio, which is a diversified portfolio, and the investment goes as follows:

• CISCO System - 15%
• Citibank - 30%
• Apple - 5%
• Ford - 35%
• Amazon - 10%
• Berkshire Hathaway - 5%

Now, on 31st December 2019, you found that the total value of the portfolio now is $114,531 since there was an annual growth of 14.5% on total investment.

Below you can see a detailed calculation after breaking down the investments in your portfolio and the returns on the same:

When you tried finding out which stocks performed well, you got to know that if you would have invested only in the financial services sector like Citibank and Berkshire Hathaway, the return would have been much lower. But the companies like CISCO System, Apple, and Amazon fared well, because of which you earned a 14.5% hike on your total investment of $100,000.Thus, you benefited from diversifying your portfolio. 

The most beneficial part of unsystematic risk is that it is not correlated with the market risk and thus, can be eliminated with the help of diversification of the portfolio. This way, you mitigated the unsystematic risk which gripped few companies such as Citibank, Ford, and Berkshire Hathaway because of some internal issue in them.

Let us see the formula used to calculate unsystematic risk now.

Formula for Unsystematic Risk

Unsystematic risk is represented by a firm’s beta coefficient. Beta coefficient is nothing but the volatility level of stock in the financial market.

Now, you can easily find the beta coefficient of your stock on an online website such as Yahoo finance. For instance, Apple Inc.’s beta coefficient on Yahoo finance is 1.17, whereas the beta coefficient of Microsoft is 0.93. Since the beta coefficient of Microsoft is lesser, it represents that it is a less volatile stock; thus, more investment can be placed in Microsoft and less in Apple Inc. 

We will calculate the overall beta or the potential risk resulting from your investment portfolio with the following formula:

Total Beta = Percentage of total investment 1 x (Beta of investment 1) + Percentage of total investment 2 x (Beta of investment 2)

In the formula above, you can find out the beta of each investment i.e., investment 1 and investment 2 with the help of following formula:

Beta = Covariance/Variance

where,

Covariance implies the measurement of how two stocks move together. In case of movement of stocks together when their prices go up or down, it is a positive covariance. On the other hand, if they move away from each other, it is a negative covariance.

Variance implies the measurement of volatility of the price of a stock over a period of time. Also, this is the measurement of a stock in relation to its mean.

Great! Moving forward, we will also find out how you can calculate the unsystematic risk so that you are able to mitigate the same.

How to Calculate Unsystematic Risk?

Calculating the unsystematic risk is simple and is measured by mitigation of systematic risk and this mitigation happens when you diversify your investment portfolio. As we discussed above, systematic risk is the one which depends on macroeconomic factors which are market factors. These factors can not be avoided since they are not internal. 

We had assumed that investment 1 can be Apple Inc.’s stocks and investment 2 is Microsoft’s stocks.

Let us assume that we are investing 40% in Apple Inc. and 60% in Microsoft. This way, we will calculate the total beta as follows:

Total Beta = .40 x (1.17) + .60 x (0.93) = 0.468 + 0.558 = 1.026

As we can see with the calculation above, we have a total beta or potential risk of 1.026 on the investment in the overall portfolio.

Let us find out how the two types of risk, i.e. systematic and unsystematic risk differ from each other.

Systematic vs Unsystematic Risk

Systematic risk

Systematic risk is also known as the non-diversifiable risk or the market risk which rises because of macroeconomic factors in the market. For instance, these factors can be broadly categorized into social, political and economic. Systematic risk can be an interest risk, inflation risk or any market risk to the firm. This kind of risk befalls the entire industry. 

Systematic risk is quite different from unsystematic risk in nature.

Unsystematic risk

Certain microeconomic factors affect a particular firm’s operations and thus, these factors lead to fluctuations in the returns of the firm. As these risk factors are internal, they can be avoided by the firm if necessary actions are taken within the organisation.

For instance, labour strikes and mismanagement of operations are a couple of reasons a firm may face adversity in the guise of unsystematic risk.

The types of unsystematic risks are business risks, financial risks, and operational risks which we will discuss in the next subtopic.

Types of Unsystematic Risks

Unsystematic risk is itself a type of risk which is controllable by an organisation. However, in case the organisation is not able to take care of any part such as management, liquidity etc., unsystematic risk can interfere with the normal operations.

There are mainly three types of unsystematic risks:

• Business risk/Liquidity risk
• Financial risk/Credit risk
• Operational risk
• Business risk/Liquidity risk

Business risk, basically, implies the type of unsystematic risk which questions whether the firm will be able to earn a considerable amount of profits or not. Every business has some usual expenses, and to cover them, there should be at least as much earning which covers the usual expenses. For instance, salaries, marketing cost, and so on.

Financial risk/Credit risk

A firm’s financial risk implies the use of financial leverage or loan that the firm may use for funding its operations or a part of the operations. Financial risk is the liability on the firm to pay interest payments on the loan(s). There can also be other debt-related obligations such as payment of the capital amount on the expiration date of the loan. In case the firm is not able to generate enough income to cover the loans and related expenses, it falls prey to the financial risk. The more a firm carries loan-related obligations, the higher is the risk. Not meeting the commitments related to leverage or loan can land any firm into trouble, which may also lead to insolvency. There are some factors which can make a firm vulnerable to financial risks, such as:

• An interest rate hike in the market can increase the expense all of a sudden as compared to the earning
• Less equity financing as compared to the leverage financing
• Management issue with regard to speculation of both expenses and income
• Usually, the analysts and investors consider a financial risk ratio, which is, Debt/Equity ratio.

Debt/Equity ratio = Total liabilities / Equity of the shareholders

The debt to equity ratio serves as the apt way of finalising the leverage amount (debt) for funding the operations since the ratio helps you keep the liabilities or debt lower than the equity. Consequently, you will not end up increasing your liabilities.

Also, if your business is spread to foreign countries, the foreign currency exchange risk is a part of financial risk. A decrease in the value of a foreign currency can lead to sudden losses since you will be receiving your payments in that country’s currency.

Operational risk

An operational risk implies the loss that every organisation is prepared to bear since it includes all those errors which are natural. The error can be:

• Employees related such as a human error
• Relating to the hardware system (computer, machine), such as a technical problem
• Relating to an old process being followed for a task that requires an advanced process

Nevertheless, there needs to be operational risk management set up so as to avoid hurting the organisation’s finances. There should be a clear determination of the number of operational errors or loss a firm is ready to incur. Moreover, some of the errors can also be corrected, but the firm must also be prepared to incur the cost of correcting those errors. Hence, total operational risk is a combination of Loss a firm is ready to bear and Cost of correcting some errors.

The operational errors, which lead to the operational risks, play a key role in the determination of programs which can help avoid such a risk. The examples of such programs are risk management programs, disaster recovery programs, and so on. Such programs help to assess the potential risk factors, communicate the same and then finalise the steps to mitigate them.

Now, we know that programs and effective measures can help mitigate operational risks.

But what about business risk and financial risk?

Let us move forward with the next topic of discussion, which is how to mitigate business risk and financial risk.

How to Protect Against Business Risk and Financial Risk?

Both the business risk and financial risk are a little more complicated than the operational risk when it comes to mitigating them. Moreover, with operational risks, the management is prepared to bear them. But, it can not be the same with business risk and financial risk, since bearing these risks can lead to a huge loss for the organisation. 

Business risk can be mitigated by decreasing unnecessary cost, for instance, marketing costs on physical marketing (wherever not required) and instead shifting to online marketing.

Financial risk also can be mitigated by the firm by taking care of the finances, for instance, by calculating the debt/equity ratio and dividing the funding between debt and equity wisely.

Let us now take a look at the measures to mitigate each risk in detail.

Measures to mitigate business risk

• Identifying the risks
• Analyse the impact of each risk & rank them on the basis of impact
• Treat the risk starting from the one that requires immediate attention
• Regularly monitor and review the identified risks
• Identifying the risks

This simply implies identifying and uncovering the risks associated with your business specifically. These can be anything from excessive expenditure on marketing, repairs, due to fraud, and so on.

Analyse the impact of each risk & rank them

After you have identified the risks which your business is more vulnerable to, you can find out how severe the impact may be and then rank each risk based on the severity. There can be such risks which a business can accept as they may not be detrimental to the business. On the other hand, some risks which can be serious enough need to be resolved at the earliest. For instance, if a crucial part of the business breaks down, it requires it to be fixed immediately. Whereas, if a non-crucial part is down for maintenance, it can wait until the important things are taken care of. 

Treat the risk starting from the one that requires immediate attention

In the step above, ranking the risks based on the severity will help you treat the most severe ones (with a considerable impact on the profits) at the earliest. Once you are done taking care of the most severe ones, you can move to the less severe in the list.

Regularly monitor and review the identified risks

All the risks which were identified and resolved should be regularly tracked and reviewed for any future inconveniences. A team of employees can be set up for the same, and the leaders or managers can implement the solutions required.

Measures to mitigate financial risk

Financial risk can be avoided by following some simple steps such as:

• Saving enough from the revenues
• Getting the business insured
• Building a business structure that maximizes the gains
• Involving the shareholders
• Saving enough from the revenues

Find out if your business can survive well without certain expenses which you are incurring. For instance, you find out that outsourcing some occasional work (such as researching statistical data) is better than hiring full-time employee(s) for the work.

Getting the business insured

Your business should be insured against certain unforeseen events such as cyber-attack, a natural disaster etc. The insurance helps you save a considerable amount of revenues and acts as a safeguard.

Building a business structure which maximizes the gains

With the right business structure, you will be spending only in the right places. For instance, you must spend on nurturing the talent you have, which makes your employees stick to the firm. A good set of employees can help you in the long run but spending on full-time employees, if you do not need them, can increase your financial risk in the guise of extra expenditure.

Basing your decisions on metrics

You must not make any decision until and unless you can measure its consequences. For instance, before holding an event, you know what you want to get out of it, which can be more clients by marketing your firm, better recognition and so on. Similarly, before taking any crucial step like hiring an employee, signing a deal, etc. you must ensure that it brings you long term benefits.