What Is Stock Specific Risk?
Also commonly referred to as unsystematic risk, stock-specific risk only impacts a person invested in a certain industry, company, or specific area of the stock market. The term risk when talking about stock options and investment is in essence the uncertainty factor involved in the return you can potentially receive on your initial investment. The higher the risk, the less secure the investment; although often the potential for high returns is what drives people with the money to spare to take the gamble.
There is some level of risk involved in any investment or stock which is known as systematic risk, but the unsystematic or specific risks are defined to one particular sector. This type of risk impacts a smaller number of holdings and assets but can often have a more probable likelihood of coming to pass and should be assessed closely before jumping on board with any of your hard-earned cash.
Stock-specific risk can often be highly unpredictable. An insurance company may be a great investment opportunity on the surface, and nine times out of ten it very well could be, but in the event of a natural disaster, insurance stocks could take an impressive hit.
If a person decides to invest in stocks with known specific risks, they should be wary of possible negative outcomes and takes the necessary steps to avoid any serious losses coming their way. A smart investor is someone who balances the risk factor, the return possibilities, and the money they are willing to put out while diversifying their stock options as effectively as possible.
What Creates Stock Specific Risk?
Specific risk is, as the name suggests, individual to each area of business or investment. For example, a specific risk to someone invested in a bus and coach company would be a staff strike amongst drivers, resulting in a complete loss of company function and income. Put simply, any possible hazard a certain industry faces that would impact business and profit is a stock-specific or unsystematic risk.
Before investing in any company, stock-specific risks are assessed and laid out clearly to mitigate any uninformed decisions, but life is unpredictable and so are stocks, so new risks may arise after the fact. If all your holdings are tied up in one industry with high stock-specific risk and something goes wrong, you can find yourself in a bad situation, so the smart thing to do is spread investments across different sectors to play the odds. This is known as diversifying. (see below)
What Are the Types of Stock Specific Risk?
Specific or unsystematic risk can mean a lot of things depending on the sector you invest in. Generally speaking, stock-specific risk can be categorized into one of five areas:
- Business Risk
Business risk can be either internal or external. An example of internal business risk would be a human error; ineffective leadership by management which results in staff strikes, ineffective working practices, or diminished employee performance levels would class as internal business-specific risk.
The internal business-specific risks could also be political, with changes in legislation impacting the way business is run and the product they sell distributed. A pharmaceutical company whose best-selling drug is decommissioned by the FDA would be harshly affected, but a clothing retail empire would take no notice; proving why investors with holdings in any industry with high levels of stock-specific risk should diversify effectively.
- Financial and Strategic Risk
Financial risk is all about how well a company’s capital is used and structured. If the company you are considering investing in does not have enough equity and an optimal level of debt to be operating in a financially sound and responsible manner, it would be considered a very high-specific risk investment. Strategic risk also pertains to finance, in the sense that poor strategic planning can lead to revenue losses which in turn would hurt the investor.
- Operational Risk
Operational risk can come from negligence or oversight during the procedure of manufacturing and production. Suppliers or third parties failing to fulfill contracts or agreements on time or an issue with data security are examples of stock-specific operational risk.
- Legal Risk
Legal risk comes when regulations or legislation come into play which can hinder, or even halt, production or business. Similar to political risk when talking about internal business, this can manifest itself in many ways. A legal risk could be on a country-wide scale if a law is passed in direct opposition to a key practice or product a company uses, or on an individual basis if a company faces direct legal action
What Is the Difference Between Specific (Unsystematic) Risk and Systematic Risk?
No investment is without risk entirely, and certain things have the power to affect and business: this is known as systematic risk. Systematic risk is the general gamble any investor must take if they want to gain a profitable return, but of course, a smart investor knows how to keep the gamble at the minimum bet.
There is no more prominent example of systematic risk than The Great Recession of 2008 when an incomprehensible sum of money was lost on the stock market. This is by no means an everyday occurrence, but it serves as a stark symbol of what systematic risk can mean.
What Is Diversification, and How Does It Help to Minimize Stock-Specific Risk?
Diversification is the only way to reduce unsystematic or stock-specific risk. Diversification is the stock industry’s way of saying play the odds, meaning the more baskets you put your eggs in, the fewer that get broken. Intelligent investors and investment advisors will always diversify holdings in a way that allows for maximum return with minimum risk. The most effective method of diversifying is to include as many different industries and sectors in your investment portfolio as is financially viable for you, that way if one risk becomes reality, you will not be impacted in the same way you would be had your entire investment equity been designated to that industry or company.