Specific risk: how to manage a company’s peculiar risk

Specific risk, also known as diversifiable risk, represents the portion of risk associated with the individual characteristics of a company or its competitors. This type of risk can be reduced through portfolio diversification, making it a crucial aspect for investors seeking to protect their returns.

What is specific risk and why is it important

Specific risk concerns individual companies and depends on peculiar factors such as capital strength, business management, and sectoral economic outlook. Unlike systematic risk, which is inherent in the performance of the market as a whole, specific risk can be mitigated by diversifying investments across multiple securities or sectors. For this reason, investors are not paid to bear this type of risk because it is avoidable.

How to manage specific risk with diversification

Diversifying one’s portfolio means investing in several companies or sectors, reducing the negative impact that a single stock might have on the entire investment. If a company faces difficulties, the specific risk of that company will not unduly affect a well-diversified portfolio, minimizing the risk of loss.

Professional investors use fundamental analysis to assess specific risk. This technique involves studying the company’s financial situation, its growth prospects, and the conditions of the industry in which it operates. This data helps determine whether a stock’s specific risk is too high or acceptable, and whether it is worth including in the portfolio.

Specific risk vs. systematic risk

Specific risk is distinguished from systematic risk (or market risk), which is the risk that cannot be eliminated even by diversifying. The latter depends on general market fluctuations and global economic events. Systematic risk is measured by beta, which indicates the sensitivity of a security to the overall market. In contrast, specific risk is related solely to the performance of a single company or sector.

Conclusion

Understanding specific risk is critical for investors who wish to protect their returns through diversification. By reducing this risk, portfolio performance can be optimized and focus on managing unavoidable risks such as systematic risk. Ultimately, a well-structured investment strategy involves identifying and reducing specific risk, enabling investors to achieve more stable returns.

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