Unsystematic risk is the portion of an investment’s total risk that belongs to one company rather than to the market as a whole, and it is the portion diversification can remove. The International Valuation Glossary, compiled jointly by the American Society of Appraisers, CBV Institute, RICS and TAQEEM, defines it as risk specific to an individual security that can be eliminated through diversification.
The Other Names for It
Four labels point at the same thing, which is why a page that never uses the word unsystematic can still be about it. The glossary records idiosyncratic risk and diversifiable risk against the entry itself, and its separate entry for company-specific risk, defined as the risk unique to a specific investment in a business in excess of the equity risk premium, size risk and/or country risk, names unsystematic risk as another name for that (International Valuation Glossary, Business Valuation, updated 2022).
What Separates Unsystematic Risk From Systematic Risk
The dividing line is whether diversification can reach the risk. The same glossary defines systematic risk as risk common to all risky securities that cannot be eliminated through diversification, also called market risk and non-diversifiable risk, and names beta as its measure (International Valuation Glossary, Business Valuation). How that measure is estimated is in beta coefficient, and the single-factor model built on it, along with the risk-free rate and the equity risk premium, is in CAPM equation.
Where a Valuation Prices It
In a closely held business valuation this risk gets priced rather than left to diversification. The build-up model measures the expected return on a security as a risk-free rate plus premiums for systematic risk, such as the equity risk premium, a size premium and an industry risk premium, plus premiums for unsystematic risk, such as a company-specific risk premium, which the glossary defines as an adjustment to the cost of equity to account for company-specific risk and also calls alpha (International Valuation Glossary, Business Valuation).
That premium is where the term stops being abstract inside an accounting practice. A few clients carrying most of the fees is one exposure of the kind, and one partner holding the relationships and the final review judgment is another. Neither is a movement of the market, so neither reaches the rate through beta, and both reach it through the company-specific leg instead.
Rev. Rul. 59-60, which the IRS applies to closely held stock for estate and gift tax purposes, already treats the second of those, the effect of losing the manager a closely held business depends on, as a pertinent factor without ever calling it unsystematic (Rev. Rul. 59-60, reproduced as Appendix A to the IRS job aid on valuing non-controlling interests in electing S corporations). What the ruling says about that, and what such a dependence does to the price of a practice, is worked through in how to value a CPA firm. Where the resulting rate sits inside the income approach is in valuation.
Common Questions
An example is any fact about one business that would move that business and leave the market where it was, which is the test any list of examples has to pass. The valuation glossary attaches three of them to company-specific risk, which are significant customer concentration, business dependence on key persons, and lack of product diversification (International Valuation Glossary, Business Valuation).
By the definition itself, diversification can eliminate it, since that is the property separating it from systematic risk. The answer is narrower than it sounds. It describes a security held inside a diversified portfolio, and it does not describe an undiversified interest in one closely held business, which is the case where the risk gets priced as a premium instead.
