It is not always possible to diversify away risks outside of the control of individual managers. After the next year rolls around, the company might find that consumers actually prefer bigger phones and watches. Much of the existing inventory for the aforementioned technology company either goes unsold or sells at a major loss. Another potential risk might be Tesla’s CEO, Elon Musk, who has cultivated a reputation as an eccentric and unpredictable genius.
Examples can include management risks, litigation risks, location risks, and succession risks. Unsystematic risk is the risks generated in a particular company or industry and may not apply to other industries or economies. Small players with low profitability and high debt are exiting the business.
As telecommunication is a capital-intensive sector, it requires enormous funding. A simple example of unsystematic risk is litigation risk, meaning the danger that a company might face legal action. For example, a company whose products are more likely to be defective will face more class-action suits than other companies in the same industry. For this reason, unsystematic risks can be broad enough to apply to many different businesses at once. What is important is that an unsystematic risk is not inherent to every security or at least not a great majority of securities.
This reputation has sometimes been an asset, but it has also courted negative attention–like in 2018, when Musk falsely hinted at a plan to take the company private. Since Musk’s behavior is more likely to harm Tesla than another automaker, it is an example of unsystematic risk. In financial jargon, the term “unsystematic” refers to a quality that is not commonly shared among many investment opportunities. This is distinct from systematic risk, the dangers inherent to the market as a whole.
Moreover, investors should be able to diversify away unsystematic risks by strategically targeting a wide enough range of holdings in their respective portfolios. The unsystematic risk is very dynamic; the nature of problems varies from each other. The enterprise which faces these problems experiences growth in profitability while the whole economy is going fine.
However, a state government decides to subsidize Firm A or perhaps it prohibits a practice commonly used by Firms B and C that allegedly harms local bird populations. The stock value for Firm A tends to rise, while the stock value for the other two firms tends to fall. Due to a recent strike by the workers of the particular region, the manufacturing plant is closed, and the production activities are stopped for a while. But the demand for automobiles is the same, and the overall economic growth is intact.
It is a pure case of unsystematic risk, and the matter is related to the agricultural segment in Europe only. So, the portfolio manager can divert the funds exposed to the agricultural industry. The funds can be diverted to US consumption, as the sector has been going very strong recently.
What makes it unsystematic is that only a few firms tend to make the same mistake at the same time. The whole of the technology sector may end up performing very well, while companies with poor entrepreneurial foresight suffer. Other risks are unsystematic, meaning that they affect Tesla more than competing manufacturers. Tesla’s operations are centered around several gigantic manufacturing plants that benefit from favorable subventions by local governments. If those municipalities were to change their policies, they would likely damage Tesla’s profits without affecting competitors. There are some political and legal risks that do affect entire industries in systematic ways, however.
Production lines are altered and capital is devoted toward smaller devices. Another way to identify unsystematic risks is to compare the specific instance of a risk with the overall example of unsystematic risk market or industry. If there is little or no substantial correlation, the risk is likely to be unsystematic. The most common examples of unsystematic risk are the risks that are specific to an individual firm.
Investors can reduce their exposure to unsystematic risks by diversifying their portfolio. Some common types of unsystematic risk include business risk, financial risk, operational risk, strategic risk, and legal or regulatory risk. Neither of these specific political or legal risks is inherent to the industry itself. If an investor purchased stock in all three firms, they may be able to diversify away losses in Firms B and C via the gains from Firm A.
The following are some examples of unsystematic risks that companies might face. While some of these risks may be fairly common, they are not evenly distributed across the entire market. Unsystematic risks occur in the case of large portfolios or funds under management. Suppose fund X has 15% exposure in the agriculture industry in Europe. Due to low harvesting conditions across Europe, commodity prices have jumped up, followed by a slump in demand and reduced yields for the farmers.
Many of these are systematic risks, meaning that they are widespread throughout the market. For example, a stock market crash would likely harm Tesla’s shareholders, along with many other companies. A shortage of silicon chips or lithium could affect the entire technology sector, including Tesla. Most unsystematic risks are related to errors in entrepreneurial judgment. For example, a technology company might perform market research and predict that consumers will want smaller cell phones and digital watches the next year.
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