What it means
Specific risk is also called unsystematic or idiosyncratic risk. It arises from events within one firm or sector, such as management errors, labour disputes, regulatory action or a failed product launch.
By contrast, systematic risk, or market risk, affects almost every investment at once, for example a recession, a sharp rise in interest rates or a financial crisis. You cannot remove this by owning more shares, because they all tend to move together.
The important point is that specific risk can be diversified away. If an investor owns only one company, a scandal there could wipe out much of their wealth, but if they own thirty companies in different industries, one failure has only a small effect.
Because it can be reduced so cheaply, financial theory says that markets do not pay investors extra return for taking specific risk. Higher expected returns are earned for bearing systematic risk, which is why concentrated bets are not rewarded on average.
Businesses face specific risk too. A company that gets 70% of its sales from one customer, depends on a single supplier or relies on one product carries more specific risk than a diversified rival.
Risk managers monitor specific risk through measures such as exposure limits, insurance, contract terms and scenario analysis. The goal is not to avoid all of it but to avoid being exposed to more than the business can survive.
In practice
Real-world examples.
Example
A pharmaceutical company announces that its main drug failed a safety trial, and its share price falls 40% in a day while the rest of the market is unchanged. An investor who held only that stock suffers heavily, but a fund with 200 holdings loses far less. If the stock were 0.5% of the fund, a 40% fall would cost the fund only 0.2%.
Example
A small manufacturer earns 65% of its revenue from one supermarket chain. When the supermarket switches supplier, the manufacturer's cash flow collapses, which shows the business was exposed to a specific risk of customer concentration. A sensible response is to seek several mid-sized customers instead of one dominant one.
Example
An airline faces a pilots' strike that grounds flights for a week. The disruption reduces its revenue and share price, but other industries are untouched, so an investor with a spread portfolio barely notices. The airline's own bondholders and suppliers, however, feel the effect directly.
Formula
Calculation
Total variance = systematic variance + specific variance
Specific variance = total variance - (beta squared x market variance)
A share has a total variance of 0.0400, a beta of 1.0 and the market has a variance of 0.0225. Systematic variance = 1.0 x 1.0 x 0.0225 = 0.0225. Specific variance = 0.0400 - 0.0225 = 0.0175. So 0.0175 / 0.0400 = 43.75% of the share's total risk is specific, and this is the part that can be reduced by diversification. The remaining 56.25% is market risk, which would stay however many shares were held.Case study
Seen in the real world.
Northfield Capital is an illustrative, fictional investment club that put $200,000 of members' money into the shares of a single energy company because it looked cheap. A pipeline accident led to fines and a loss of public trust, and the shares fell 60%.
The club lost $120,000 on that one holding (60% of $200,000), even though the wider stock market barely moved. A review found that nobody had considered how much of the portfolio depended on one company.
The illustrative club adopted a rule that no single share could exceed 10% of the total, and it added funds covering other sectors and countries. The next time a holding had bad news, the loss was a small share of the whole. Members also agreed to review sector exposure twice a year.
Watch out
Common mistakes.
- Believing a well-known, large company has no specific risk, when large firms also suffer scandals, product failures and lawsuits, sometimes with very large costs.
- Thinking diversification removes all risk, when it removes only specific risk and leaves market risk in place.
- Counting several holdings in the same industry as diversified, when one sector event can hit them all together.
Questions
People also ask.
What is the difference between specific risk and systematic risk?
Specific risk affects one company or sector and can be diversified away, while systematic risk affects the whole market and cannot.
How many holdings are needed to diversify away most specific risk?
There is no exact number, but spreading across a few dozen businesses in different industries removes much of it, and index funds do this automatically. The benefit of each extra holding shrinks as the portfolio grows.
Does a business have specific risk too?
Yes, a company can face concentration in customers, suppliers or products, and it can reduce exposure through contracts, insurance and a broader base. A company with one factory, for example, faces a specific risk that a fire or flood stops all output.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%