What it means
Total investment risk splits into two parts. Systematic risk comes from forces that move nearly all shares at once, such as interest rate changes, recessions or a general loss of confidence, while unsystematic risk comes from events inside a single business, such as a strike, a lawsuit or a failed product launch.
The practical consequence is one of the more useful ideas in finance: investors are not rewarded for carrying unsystematic risk. Since it can be removed at almost no cost simply by holding more names, the market offers no extra expected return for bearing it, and expected returns are tied only to the systematic part.
In numbers, the split shows up in the variance of a share's returns. Comparing a share's returns against the market gives an R squared, which is the proportion of its movement explained by the market, and whatever is left over is the company specific piece.
Diversification does the heavy lifting surprisingly quickly. Most of the company specific risk in an equity portfolio disappears once you hold roughly twenty to thirty shares spread across different industries, and each further name adds a steadily smaller improvement.
Company managers face the same distinction, though they cannot diversify their own firm away. They manage unsystematic risk with insurance, second suppliers, a broad customer base and contingency planning, which is why a single client accounting for 40% of sales makes a board nervous.
In practice
Real-world examples.
Example
An investor holding shares in a single mining company loses 40% of their money when a tunnel collapse halts production for a year. A colleague with the same sector exposure held through a fund of thirty miners barely registers the event in their portfolio value.
Example
A pension fund's investment committee reviews a portfolio where two positions make up 30% of assets. It trims both, not because it dislikes the companies but because it is not being paid any extra return for carrying that concentration.
Example
A manufacturer with one customer worth 45% of revenue is told by its bank that its borrowing rate reflects that concentration. Winning three mid sized clients over the following year reduces the company specific risk and the loan is repriced at a lower margin.
Think of it
“Unsystematic risk is like individual players getting injured on sports teams. If you own all teams, some players always recover as others get hurt.
Formula
Calculation
Total variance = systematic variance + unsystematic variance
Systematic variance = beta squared x market variance
R squared = systematic variance / total variance
A share has an annual standard deviation of returns of 20%, so its total variance is 20 x 20 = 400 in percentage squared terms. The market's standard deviation is 10%, giving a market variance of 10 x 10 = 100, and the share's beta is 1.2.
Systematic variance = 1.2 x 1.2 x 100 = 144. Unsystematic variance = 400 - 144 = 256, and the square root of 256 is 16, so 16 percentage points of the share's 20% volatility is company specific and diversifiable.
R squared = 144 / 400 = 0.36, meaning only 36% of this share's movement is explained by the market and the other 64% comes from things happening inside the company. An investor holding it as one position among forty would expect most of that 64% to cancel out against the specific risks of the other holdings.Case study
Seen in the real world.
The following is an illustrative and fictional story. Emberline Capital, an invented boutique investment firm, ran a concentrated portfolio of twelve shares and marketed it on the strength of deep research into each holding. For four years the approach worked and returns comfortably beat a broad index.
In the fifth year, two holdings ran into company specific trouble in the same quarter: one lost a patent case and the other discovered an accounting error in a subsidiary. Neither event had anything to do with the wider market, which was flat, yet the fictional fund fell 18% while the index it was measured against barely moved.
Emberline's illustrative response was not to abandon concentration but to be honest about what it was selling. It restated its literature to explain that clients were being asked to accept unsystematic risk deliberately, in the hope that superior research would more than compensate, rather than being told the portfolio was simply a better version of the market.
Watch out
Common mistakes.
- Believing that holding many investments removes all risk, when diversification only removes the company specific part and leaves market wide movements untouched.
- Assuming twenty holdings are diversified when they are all in one sector, since a sector shock hits them together and behaves much like a single position.
- Expecting a higher return for taking concentrated single company risk, when pricing models assume that risk can be diversified away and therefore pay nothing for it.
Questions
People also ask.
How many shares does it take to diversify most of it away?
Roughly twenty to thirty holdings across different industries removes the bulk of company specific risk, with diminishing benefit after that.
Is unsystematic risk relevant to a private business owner?
Very much so, because an owner has almost all their wealth in one company and cannot diversify it, which is why insurance and customer spread matter so much.
What is the difference between unsystematic risk and beta?
Beta measures only the systematic part, the sensitivity to market movements, and says nothing about the company specific risk sitting alongside it.
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