In the last section, we discussed how systematic risk affects the entire market and cannot be avoided with diversification. We’ll now dive into types of non-systematic risk, which affect specific investments or sectors.
Financial risk
When a company runs into financial problems, they face financial risk. This is typically due to being over-leveraged, which means the company borrowed too much money. Tesla (symbol: TSLA), for example, faced financial risk for many years. Even if the company’s product is in high demand, they could still face significant problems if they owe too much money to creditors. Stock prices tend to decline when these problems occur, which could significantly affect a common stock investment.
Business risk
Business risk is similar to financial risk, but slightly different. Instead of financial problems due to large amounts of debt, business risk occurs when a company is having difficulty with its general business. Radio Shack is a good example of how this risk can be a huge problem. Although there are some stores still around today, Radio Shack’s business peaked in 1999. Over the years, they lost business to companies like Best Buy and Amazon, while failing to evolve with the changing technological landscape. 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 drives the stock value downward.
Regulatory risk
When a company faces challenges due to a current or potential government regulation, investors experience regulatory risk. When Mark Zuckerberg (CEO of Meta (Facebook)) was asked to testify to Congress regarding privacy concerns, Meta encountered regulatory risk. If our politicians determined regulations were needed to prevent privacy-related problems, it would negatively affect Meta’s business. The company would be forced to spend millions of dollars updating training protocols, aspects of their website, and general business practices. While it may be good for society, social media regulations would drive down the value of Meta’s stock.
Liquidity risk
Many common stocks trade on exchanges, like the New York Stock Exchange. You’ll learn more about stock markets when you go into the secondary market unit. For now, assume a significant amount of trading occurs on exchanges and that it’s easy to buy or sell stocks there.
Not all publicly traded stocks trade on exchanges. Many smaller or start-up companies are traded in the OTC markets. Without going into too much detail, (you’ll learn more in the OTC markets chapter), stocks trading in the OTC markets tend to have less trading volume than those that trade on exchanges. As a consequence, it may be difficult for an investor to sell a lesser-known stock trading in the OTC markets. Whenever an investor has trouble turning their stock into cash, they face liquidity risk, sometimes referred to as marketability risk. In order to sell an investment with little or no demand, it may require the investor to drop their asking price substantially.
Here’s a video breakdown of a practice question on non-systematic risks:
In summary, these are the non-systematic risks that affect specific investments or sectors or the market. Unlike systematic risks, non-systematic risks can be reduced through diversification. The more investments an investor owns, the less they rely on the benefits and risks of one particular investment. When an investor lacks diversification, they are subject to concentration risk, which amplifies the non-systematic risks we discussed in this section. For example, an investor’s exposure to financial risk is especially significant if they’re only invested in one company with large debt levels. The risk is concentrated and amplified!
For the exam, you’ll need to know the two big categories (systematic vs. non-systematic) and which risks fall into each of those categories.
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