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2.19 Non-Systematic Risk

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Securities Industry Essentials SIE

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1 Introduction

About the SIE Exam How to Use This Course

2 Chapter 1: Knowledge of Capital Markets

1.1 Regulatory Bodies 1.2 State Regulation 1.3 Market Participants 1.4 Types of Markets 1.5 The Exchanges 1.6 OTC Markets 1.7 Economic Policies 1.8 Interest Rates 1.9 Business Cycles 1.10 International Economics

3 Chapter 2: Understanding Products and Their Risks

2.1 Common Stock Basics 2.2 Corporate Actions 2.3 Preferred Stock 2.4 ADRs 2.5 Bond Basics 2.6 Yields 2.7 U.S. Treasury Securities 2.8 Corporate Bonds 2.9 Municipal Bonds 2.10 Money Market Instruments 2.11 Options Basics 2.12 Hedging Strategies 2.13 Mutual Funds 101 2.14 Mutual Fund Fees 2.15 ETFs 2.16 UITs & REITs 2.17 DPPs 2.18 Systematic Risk 2.19 Non-Systematic Risk 2.20 Mitigation Strategies

4 Chapter 3: Trading, Customer Accounts and Prohibited Activities

3.1 Order Types 3.2 Trade Settlement 3.3 Quoting 3.4 Account Types 3.5 Account Registration 3.6 Retirement Plans 3.7 Education Savings 3.8 AML Rules 3.9 Market Manipulation 3.10 Insider Trading 3.11 Customer Protection

5 Chapter 4: Overview of Regulatory Framework

4.1 Registration 4.2 Continuing Education 4.3 Employee Conduct 4.4 Correspondence

2.19 Non-Systematic Risk

Key Takeaways Explain This Topic AI

Unsystematic risk (diversifiable risk) affects individual companies or sectors and can be reduced or eliminated through diversification

Business risk relates to company operations including competition, technology, management, labor, and supply chain factors

Financial risk relates to company debt levels and leverage; high debt-to-equity ratios increase default risk

Credit risk (default risk) is the risk that bond issuers fail to make payments; measured by credit ratings from AAA (lowest risk) to D (default)

Investors are not compensated for unsystematic risk because it can be eliminated through proper diversification

Last updated: January 2026

Non-Systematic Risk (Unsystematic Risk)

While systematic risk affects the entire market, unsystematic risk (also called non-systematic, diversifiable, or company-specific risk) affects only individual companies or industries. The key difference: unsystematic risk CAN be reduced or eliminated through diversification.

What Is Unsystematic Risk?

Unsystematic risk is risk specific to a company, industry, or sector that does not affect the broader market. It results from factors unique to a particular investment.

Key Characteristics

  • Feature Description
  • Scope Affects individual companies or sectors
  • Diversifiable? Yes —can be reduced or eliminated
  • Examples Management changes, product recalls, strikes
  • Measurement Standard deviation (total risk)
  • Compensation Investors are NOT compensated for this risk

Key Concept: Because unsystematic risk can be eliminated through diversification, investors do not receive extra return for bearing it.

  • Types of Unsystematic Risk
  • Business Risk

Business risk relates to a company operations and ability to generate revenue.

  • Source Example
  • Competition New competitor enters market
  • Technology Products become obsolete
  • Management Poor strategic decisions
  • Labor Strikes or workforce issues
  • Supply chain Component shortages
  • Financial Risk

Financial risk relates to how a company finances its operations.

  • Factor Risk
  • Debt levels High leverage increases default risk
  • Interest coverage Inability to pay interest obligations
  • Cash flow Insufficient liquidity
  • Credit rating Downgrade increases borrowing costs

Key Point: Companies with high debt-to-equity ratios have higher financial risk. If earnings decline, they may struggle to meet debt obligations.

Credit Risk (Default Risk)

Credit risk is the risk that a bond issuer will fail to make interest or principal payments.

  • Rating Credit Risk
  • AAA/AA Very low
  • A/BBB Low to moderate
  • BB and below (junk) High
  • D In default
  • Call Risk

Call risk is the risk that a bond will be redeemed before maturity, usually when interest rates fall.

  • Issuer calls bonds to refinance at lower rates
  • Investor must reinvest at lower current rates
  • Affects callable bonds and preferred stock
  • Liquidity Risk

Liquidity risk is the risk that an investment cannot be quickly sold at fair value.

  • Highly Liquid Less Liquid
  • Large-cap stocks Small-cap stocks
  • Treasury securities Municipal bonds
  • ETFs Limited partnerships
  • Legislative/Regulatory Risk

Legislative risk is the risk that new laws or regulations will negatively impact an investment.

  • Changes in tax laws
  • Industry-specific regulations
  • Environmental requirements
  • Trade restrictions
  • Event Risk

Event risk is the risk from unexpected events affecting a specific company.

  • Mergers and acquisitions
  • Natural disasters damaging facilities
  • Lawsuits and legal judgments
  • Management fraud or scandals
  • Reducing Unsystematic Risk: Diversification

Diversification is the primary tool for reducing unsystematic risk.

How Diversification Works

By spreading investments across many securities, the impact of any single company problems is reduced.

  • Portfolio Size Unsystematic Risk
  • 1 stock Maximum exposure
  • 5 stocks Moderate reduction
  • 10 stocks Significant reduction
  • 20+ stocks Most eliminated
  • 30+ stocks Essentially eliminated
  • Diversification Methods

Method Description

By sector Technology, healthcare, finance, etc.

  • By company size Large-cap, mid-cap, small-cap
  • By geography Domestic, international, emerging markets
  • By asset class Stocks, bonds, real estate
  • By maturity Short-term, intermediate, long-term bonds
  • Systematic vs. Unsystematic Risk Comparison
  • Factor Systematic Risk Unsystematic Risk
  • Also called Market risk Diversifiable risk
  • Scope Entire market Individual companies
  • Diversifiable? No Yes
  • Examples Inflation, interest rates Business failures, recalls
  • Measurement Beta Standard deviation
  • Compensation Yes—higher expected return No—can be eliminated
  • Total Risk

Total risk is the combination of systematic and unsystematic risk: Total Risk = Systematic Risk + Unsystematic Risk \text{Total Risk} = \text{Systematic Risk} + \text{Unsystematic Risk} Total Risk = Systematic Risk + Unsystematic Risk

  • Measured by standard deviation
  • A diversified portfolio has mostly systematic risk remaining
  • An undiversified portfolio has both types
  • Practical Application
  • For Individual Stock Investors
  • Diversify across at least 20-30 stocks
  • Spread across different sectors
  • Consider international exposure
  • No single position should dominate
  • For Fund Investors

Mutual funds and ETFs provide instant diversification:

  • S&P 500 index fund = 500 large-cap stocks
  • Total stock market fund = thousands of stocks
  • One fund can eliminate most unsystematic risk
  • Key Takeaways
  • Unsystematic risk is company-specific and diversifiable
  • Main types: business, financial, credit, call, liquidity, regulatory
  • Diversification reduces unsystematic risk
  • 20-30 stocks can eliminate most unsystematic risk
  • Investors are NOT compensated for unsystematic risk
  • After diversification, only systematic risk remains