Specific Risk

Specific Risk (also known as 'unsystematic risk', 'diversifiable risk', or 'idiosyncratic risk') is the type of investment risk that is unique to a single company, industry, or asset. Think of it as the “uh-oh” moment that torpedoes one particular stock but leaves the rest of the market unfazed. These are company-specific blunders and misfortunes: a catastrophic factory fire, a promising drug failing its clinical trials, a massive accounting scandal, or a brilliant new competitor suddenly stealing market share. Specific risk is the polar opposite of systematic risk (also called market risk), which is the broad risk affecting the entire market, like a recession or a change in interest rates. The crucial difference? You can't do much about systematic risk—it's the price of admission for investing. Specific risk, however, is a foe you can, and absolutely should, defeat.

So, how do you conquer specific risk? With a simple, yet profoundly powerful, tool: diversification. The logic is as old as the saying, “Don't put all your eggs in one basket.” If you invest all your money in a single company, you are completely exposed to its unique fate. If that company soars, you're a genius. If it crashes, your savings are decimated. By spreading your investments across many different companies, preferably in different industries and even different countries, you dramatically reduce the impact of any single company's failure. When one of your stocks gets hit by bad news (a dropped egg), the negative impact is cushioned by all the other, unaffected stocks in your portfolio (your other baskets of eggs). The individual, random events that plague single companies tend to cancel each other out in a larger portfolio. This allows the underlying, long-term performance of your collection of businesses to shine through, free from the noise of isolated disasters.

This is a classic debate, especially for a value investor. You don't want to own so many companies that you can't keep track of them—a problem sometimes called “diworsification.” Academic studies have shown that the lion's share of specific risk can be eliminated by holding a portfolio of around 15 to 20 different, uncorrelated stocks. The risk-reduction benefit diminishes with each new stock you add. The jump from one stock to five is massive; the jump from 30 to 35 is tiny. This is why many legendary investors, like Warren Buffett, advocate for a concentrated portfolio of their very best ideas. They believe it's better to own a handful of wonderful businesses they understand deeply than to own a little bit of everything, including mediocre companies, which is what you effectively do when buying broad index funds. The goal isn't just to own many things, but to own a carefully selected group of quality businesses purchased at attractive prices.

Imagine an investor, Jane, has built a portfolio. Let's look at two of her holdings to see how diversification tames specific risk.

Jane owns shares in “GeneCure Inc.,” a biotech firm with a promising new cancer drug. Hopes are high. Suddenly, news breaks: the drug failed its final stage of trials. It’s worthless. GeneCure's stock plunges 80% in a single day. This is a devastating, company-specific event.

Luckily, Jane also owns shares in “SolidStaples,” a boring but reliable supermarket chain. SolidStaples' business is completely unaffected by the drama at GeneCure. People still need to buy milk and bread. Its stock chugs along, business as usual.

If Jane had only owned GeneCure, her investment would be in ruins. But because she also owns SolidStaples and 18 other different companies (a baker, a software firm, a European bank, etc.), the 80% drop in one small part of her portfolio is a painful sting, not a knockout blow. The disaster at GeneCure is contained. The overall value of her portfolio might dip for a day, but it is protected from catastrophe. This is specific risk being successfully managed.

As an investor, you get paid for taking on market risk—the risk of the whole economy having ups and downs. You do not get paid for taking on specific risk. It is a completely uncompensated danger. A single company’s stock price can go to zero for reasons that have nothing to do with the broader market, and you get no extra reward for exposing yourself to that possibility. Therefore, your job is to eliminate it. Build a portfolio, not a collection of lottery tickets. Whether it’s 15 stocks or 30, ensure you are not reliant on the fate of any single business. By diversifying intelligently, you shield yourself from isolated calamities and are left with the one risk you want to take: the risk that a thoughtfully selected group of good businesses will become more valuable over time.