Quick Answer
Unsystematic risk is company-, industry-, or issuer-specific risk that diversification can reduce or eliminate by spreading holdings across issuers with low correlation. NASAA's outline names credit, legal/regulatory, financial, and issuer-specific (business) risk; liquidity, political, and call risk are also commonly tested. The more issuers held, and the less correlated they are, the more unsystematic risk falls.
The prior lesson covered risks that hit the whole market. This lesson covers the mirror-image category: risks tied to one company, industry, or issuer that an investor can reduce simply by holding more of them.
What Is Unsystematic Risk?
Unsystematic risk is the risk specific to a particular company, industry, or issuer. Also called diversifiable risk, company-specific risk, or non-systematic risk.
- Can be reduced or eliminated through diversification: holding securities across different companies, industries, and asset classes
- The amount of unsystematic risk in a portfolio depends on the number of securities held and the correlation between them
The NASAA exam outline explicitly names four unsystematic risks: credit risk, legal/regulatory risk, financial risk, and issuer-specific risk.
What Is Credit (Default) Risk?
Credit risk (default risk) is the risk that a bond issuer fails to make interest or principal payments.
- Also called default risk
- Measured by credit ratings from Moody's, S&P, and Fitch
- U.S. Treasuries have virtually no credit risk
How Does Financial Risk Differ From Business Risk?
Financial risk is the risk arising from a company's use of debt, or leverage.
- Higher debt-to-equity ratios increase the likelihood of financial distress or default
Issuer-specific risk (business risk) is the risk tied to a particular company's operations, management, products, competitive position, or business model.
- Can be reduced by diversifying across many issuers so no single company's failure devastates the portfolio
- Represents the uncertainty about a company's operating performance
- Examples: product recalls, labor disputes, loss of market share, failed product launches, and technology obsolescence
A company can have excellent operations, meaning low business risk, but still fail because it borrowed too much money, meaning high financial risk. Financial risk measures the debt burden, not the quality of the business itself.
What Is Legal/Regulatory Risk?
Legal/regulatory risk is the risk that changes in laws, regulations, or legal actions negatively affect a specific company or industry.
- Examples: new environmental regulations on one sector, or lawsuits against a company
What Other Unsystematic Risks Show Up on the Exam?
The four risks above are specifically named in the NASAA exam outline. Other unsystematic risks commonly appear on the exam as well:
- Liquidity risk: the risk of being unable to sell an investment quickly without a significant price concession. Illiquid examples include direct participation programs (DPPs), non-traded real estate investment trusts (REITs), hedge funds, and restricted securities
- Political risk: the risk that government actions or political instability in a specific country affect investments tied to that country. Distinct from broad geopolitical risk, which is systematic and affects the global market rather than one country
- Call risk: the risk that an issuer redeems a callable bond before maturity, forcing the investor to reinvest at potentially lower rates
Exam Tip: Gotchas
Political risk is unsystematic; geopolitical risk is systematic. Political risk targets a specific country's policies, such as nationalization in one emerging market. Geopolitical risk sweeps the broader global market, such as a war between major powers. The exam tests this distinction directly.
Systematic vs. Unsystematic Risk at a Glance
| Feature | Systematic Risk | Unsystematic Risk |
|---|---|---|
| Scope | Entire market | Specific company/industry/issuer |
| Diversifiable? | No | Yes |
| Also called | Market risk, non-diversifiable | Diversifiable risk, company-specific |
| Examples | Interest rate, sector, geopolitical | Credit, legal/regulatory, financial, issuer-specific |
| Measured by | Beta | No single standard measure |
| Mitigation | Hedging, asset allocation | Diversification |
Exam Tip: Gotchas
- Asset allocation and diversification are not the same tool, even though this table lists them side by side. Diversification means holding many different securities or issuers so no single company's failure sinks the portfolio; it cancels out company-specific (unsystematic) risk through low correlation among individual holdings.
- Asset allocation means setting the mix of broad asset classes, such as stocks, bonds, cash, and alternatives. It manages exposure to market-wide (systematic) risk, since different asset classes respond differently to the same economic forces. A portfolio holding 200 different stocks is highly diversified but still carries full stock-market systematic risk; shifting some of that money into bonds or cash is what actually reduces that exposure.
Summary of Unsystematic Risks
| Risk | Source | Can It Be Diversified? |
|---|---|---|
| Credit | Default on debt obligations | Yes |
| Financial | Leverage/capital structure | Yes |
| Legal/Regulatory | Government agencies, litigation | Yes |
| Issuer-Specific | Company operations, management | Yes |
| Liquidity | Inability to sell quickly | Partially |
| Political | Country-specific government actions | Yes |
| Call | Issuer redeems bond early | Yes |
Exam Tip: Gotchas
Credit risk is unsystematic, meaning specific to an issuer, even though multiple issuers can default in a recession. Interest rate risk is systematic because rate changes affect all fixed-income securities simultaneously. If a question says a risk "can be reduced through diversification," the answer is unsystematic risk.
What Should You Check on Exam Day?
- Can you name all seven unsystematic risks and explain why diversification reduces each one?
- Do you know which four NASAA's outline explicitly names: credit, legal/regulatory, financial, and issuer-specific?
- Can you separate financial risk (leverage) from business risk (operations) when a company fails?
- Do you know the difference between political risk (one country, unsystematic) and geopolitical risk (global, systematic)?
- Can you explain why diversification and asset allocation manage different categories of risk, not the same one?