In the last section, you saw that systematic risk affects the entire market and can’t be eliminated through diversification. Now we’ll look at non-systematic risk (also called unsystematic risk), which affects specific companies, investments, or sectors.
A company faces financial risk when it runs into financial trouble, often because it’s over-leveraged (it borrowed too much money). Tesla (symbol: TSLA), for example, faced financial risk for many years.
Even if a company’s product is in high demand, heavy debt can create serious problems if the company can’t meet its obligations to creditors. When these issues appear, stock prices often decline, which can significantly affect a common stock investment.
Business risk is related to financial risk, but it comes from the company’s operations rather than its debt. Business risk occurs when a company struggles with its core business - such as losing customers, falling behind competitors, or failing to adapt.
Radio Shack is a classic example. Although some stores still exist today, Radio Shack’s business peaked in 1999. Over time, it lost business to companies like Best Buy and Amazon and didn’t keep up with changes in technology and consumer behavior. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring their finances. When a common stock investment faces business risk, it tends to push the stock’s value downward.
Investors face regulatory risk when a company’s business could be harmed by current or potential government regulation. For example, when Mark Zuckerberg (CEO of Meta (Facebook)) was asked to testify to Congress regarding privacy concerns, Meta encountered regulatory risk.
If lawmakers decide new regulations are needed to address privacy issues, Meta’s business could be negatively affected. The company might need to spend millions of dollars updating training protocols, parts of its website, and general business practices. Even if regulation benefits society, it can still reduce a company’s profitability and drive down the value of its stock.
Many common stocks trade on exchanges, like the New York Stock Exchange. You’ll learn more about stock markets in the secondary market unit. For now, assume that exchange-listed stocks generally trade frequently, so it’s usually easy to buy or sell them.
Not all publicly traded stocks trade on exchanges. Many smaller or start-up companies trade in the OTC markets. Without going into too much detail (you’ll learn more in the OTC markets chapter), OTC stocks tend to have lower trading volume than exchange-listed stocks.
Because fewer buyers and sellers are available, it may be difficult to sell a lesser-known OTC stock quickly. When an investor has trouble converting an investment into cash, they face liquidity risk (also called marketability risk). To sell a security with little demand, the investor may have to lower the asking price substantially.
Here’s a video breakdown of a practice question on non-systematic risks:
In summary, non-systematic risks affect specific investments or sectors. Unlike systematic risks, non-systematic risks can be reduced through diversification. The more investments an investor owns, the less the portfolio depends on the performance of any single investment.
When an investor lacks diversification, they face concentration risk, which can amplify the non-systematic risks covered in this section. For example, financial risk becomes much more significant if an investor owns stock in only one company that has high debt levels. In that case, the risk is concentrated in a single position.
For the exam, you’ll need to know the two broad categories (systematic vs. non-systematic) and which risks fall into each category.
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