Understanding and Mitigating Specific Risk in Investing

What Is Specific Risk in Investing?

Specific risk is an investment hazard that applies only to a particular company, industry, or sector. Business risks can be categorized into internal and external risks.

Specific risk is the opposite of systemic risk which affects almost every company and industry. Specific risk is also referred to as unsystematic risk or diversifiable risk.

An investor can minimize both hazards by diversifying.

Understanding the Concept of Specific Risk

When considering whether to buy, hold, or sell a stock or any other asset, investors consider the possible risks. That is, what can cause the investment to go sour?

There are systemic risks that affect the economy as a whole and most of the industries and companies in it. A steep rise in crude oil prices pushes up the price of transporting goods, reduces the disposable income that consumers can spend, and even increases the pressure on companies to raise salaries to offset the money lost at the gas pump.

There also are risks that affect most, but by no means all, industries. A blizzard can cripple most businesses for days, but makers of snowblowers and down jackets do very well.

Specific risks are peculiar to one stock, sector, or industry. A pharmaceutical company may have a new drug rejected by the Food and Drug Administration (FDA) or an old one removed from the market. Claims from a natural disaster could damage the annual results of an insurer.

Identifying Company-Specific Risks

Two factors cause company-specific risks:

• Business Risk: Internal or external issues may cause business risk. Internal risk relates to the operational efficiency of the business. Management failing to protect a new product with a patent would be an internal risk, resulting in a loss of competitive advantage. The FDA banning a specific product that a company sells is an example of external business risk.
• Financial Risk: This relates to the capital structure of a company. A company needs to have an optimal level of debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow.

How to Reduce Specific Risk with Diversification

Investors can reduce specific risk by diversifying their portfolios. Economists Lawrence Fisher and James H. Lorie found that specific risk decreases significantly if a portfolio holds approximately 30 securities. The securities should be in various sectors so that stock- or industry-specific news can affect only a minority of the assets in the portfolio. 

For example, a portfolio might have exposure to healthcare, basic materials, financial, industrial goods, and technology.

A mix of uncorrelated asset classes should also be included in a portfolio to reduce specific risk. This means investing in a selection of assets that do not move in the same direction. Bonds, for example, do not move up or down with the fluctuations of stocks.

Investors could use exchange-traded funds (ETFs) to diversify their portfolios. ETFs can be used to track a broad-based index, such as the Standard & Poor’s 500 Index, or to follow specific industries, currencies, or asset classes. For example, investors could reduce specific risk by investing in an ETF that has a balanced allocation of asset classes and sectors, such as the iShares Core Moderate Allocation fund or the Invesco CEF Income Composite ETF.

This means that adverse news affecting a specific asset class or sector won’t have a material impact on the portfolio’s overall return.