Unsystematic Risk

An agent tells a nervous prospect: "Spread your money across forty different companies in ten industries and you have eliminated your risk - a broad decline can no longer hurt you." The statement is:

1. A.accurate, because a portfolio of forty issuers across ten industries is large enough that individual outcomes offset one another completelyOffsetting individual outcomes is exactly the unsystematic risk that diversification removes. It leaves market risk untouched.
2. B.misleading, because diversification reduces unsystematic risk but does not eliminate systematic market riskCorrect. A broad decline still hits a well-diversified portfolio; only issuer-specific risk is diversified away.
3. C.accurate, provided none of the forty companies is in the same industry as anotherEven forty different industries do not remove market risk.
4. D.misleading only because forty holdings is too few; the statement would be accurate at roughly two hundred holdingsNo number of stock holdings eliminates systematic risk.

Why: Diversification addresses UNSYSTEMATIC risk - the risk attaching to a particular company, industry or issuer - and holding many unrelated positions does reduce it substantially. It does nothing about SYSTEMATIC or market risk, the risk that securities generally fall together in response to interest rates, recession, or a broad repricing of assets. In a market-wide decline a portfolio of forty stocks across ten industries falls too. Telling a prospect that diversification eliminates risk is a misstatement of a material fact, and the fact that it is a familiar piece of shorthand does not make it accurate.

Legislation changes the tax treatment of dividends for all taxpayers, and dividend-paying stocks across every industry fall. This exposure is best classified as:

1. A.Business risk, because the affected companies must now reconsider their payout policies.Wrong. Business risk concerns how well a particular firm runs its operations, not an alteration of the tax code.
2. B.Nonsystematic risk, because only companies that pay dividends were affected by the change.Wrong. The affected group spans every industry, so no amount of spreading across sectors avoids it.
3. C.Credit risk, because the change reduces the cash ultimately available to shareholders.Wrong. Credit risk concerns an issuer's ability to service its debts, which a dividend tax change does not determine.
4. D.Systematic risk, because a change in law reaches the entire market at the same time.Correct. Legislative and political risk is market-wide by nature and cannot be diversified away.

Why: Systematic risk covers the influences that move broad markets: interest rates, inflation, recession, war, and changes in law and regulation. A tax change applying to all dividend-paying shares reaches across industries, so a portfolio spread over many sectors is exposed just the same. Nonsystematic risk is tied to a particular issuer or a narrow group, which is why adding unrelated holdings dilutes it. Had the legislation targeted one industry alone, a broadly spread portfolio would have absorbed only a fraction of the impact.

Nonsystematic risk is also referred to as:

1. A.Market riskMarket risk is another name for SYSTEMATIC risk — the opposite category.
2. B.Undiversifiable riskUndiversifiable describes systematic risk; swapping the two labels is the trap.
3. C.Purchasing-power riskInflation risk is one specific systematic risk, not a synonym for nonsystematic risk.
4. D.Diversifiable riskCorrect. Nonsystematic risk is the diversifiable, company-specific kind.

Why: Nonsystematic risk goes by several names — unsystematic risk, specific risk, and diversifiable risk — all pointing to risk tied to one company or industry that diversification can reduce.

Analyst Beata Nowakowski compares two companies in the same industry. Halstrom Tooling has volatile operating earnings but carries no debt. Verrance Tooling has very steady operating earnings but has financed half its assets with fixed-rate debt. Which statement correctly identifies the dominant risk at each company?

1. A.Both companies face primarily business risk, since they operate in the same industry and therefore face the same operating environment.Incorrect. Operating in the same industry equalizes the business environment but not the capital structure. Verrance's fixed-cost debt adds a risk Halstrom does not carry.
2. B.Halstrom's principal exposure is business risk - variability in operating earnings from the nature of its operations - while Verrance's is financial risk, the extra variability in returns to equity created by using fixed-cost debt.Correct. Business risk arises from operations; financial risk is layered on top of it by leverage, because interest must be paid before equity holders receive anything.
3. C.Halstrom faces financial risk because volatile earnings make borrowing expensive, and Verrance faces business risk because it must service debt.Incorrect, and the labels are reversed. Financial risk comes from the use of debt; business risk comes from the variability of operating results.
4. D.Neither faces meaningful risk of either kind, because both are established firms in a mature industry.Incorrect. Maturity may moderate business risk, but it does not eliminate either exposure, and it does nothing about the effect of leverage on equity returns.

Why: Business risk is the variability of a company's operating earnings arising from the nature of its operations - demand cycles, input costs, competition, operating leverage. Halstrom's swings in operating income with no debt outstanding are pure business risk. Financial risk is the ADDITIONAL variability imposed on the returns available to equity holders by the use of fixed-cost financing. Verrance's operating results are stable, but because interest must be paid before shareholders receive anything, a given percentage change in operating income produces a larger percentage change in earnings available to equity, and a severe downturn raises the possibility of default.