Unsystematic Risk

The foundational insight of Modern Portfolio Theory — developed by Harry Markowitz in his 1952 paper Portfolio Selection published in the Journal of Finance — is that the risk of a portfolio, measured as the variance of its return, depends not only on the variances of its individual holdings but also on the covariances between them, so that diversification reduces risk but, because the returns on different assets are correlated in practice, cannot eliminate all of it. The Capital Asset Pricing Model that William Sharpe built on that framework in 1964 draws the implication that rational investors should diversify away unsystematic risk because doing so reduces total portfolio risk without sacrificing expected return, leaving only the systematic risk that the market compensates through the equity risk premium. Because unsystematic risk is entirely diversifiable and therefore entirely avoidable at no cost, the Capital Asset Pricing Model predicts that the market pays no additional expected return for bearing it — making unsystematic risk the only category of investment risk for which investors receive no compensation. 

Unsystematic risk is directly and extensively tested on the Series 65 examination in the context of Modern Portfolio Theory, the CAPM, the total risk decomposition, diversification mechanics, and the investment justification for holding diversified rather than concentrated portfolios.

The Total Risk Decomposition — Where Unsystematic Risk Fits

The total risk of any individual security — commonly reported as the standard deviation of its historical returns — can be decomposed into two mutually exclusive and exhaustive components. The decomposition is additive in variance, the square of the standard deviation: the variance of the security's return equals its systematic variance plus its unsystematic variance, while the two components' standard deviations do not sum to the total standard deviation.

Measured as variance, total risk equals systematic risk plus unsystematic risk.

Systematic risk is the portion of total volatility correlated with broad market movements — the component that moves in tandem with economy-wide forces affecting all securities simultaneously. When the Federal Reserve raises interest rates, when inflation accelerates unexpectedly, when a recession begins — these forces move virtually all securities in the same direction, and the systematic risk component of each security's return reflects its sensitivity to these market-wide forces. Systematic risk cannot be reduced through diversification because holding more assets does not eliminate the common market-wide force affecting all of them simultaneously.

Unsystematic risk is the remaining portion of total volatility — the component attributable to factors specific to the individual company or industry that are largely uncorrelated with market-wide forces and with similar factors at other companies. A pharmaceutical company's unexpected drug trial failure, a retailer's supply chain disruption, a technology company's data breach, a manufacturer's product recall, a mining company's unexpected ore grade disappointment — these are unsystematic events because they affect one company or a small group of related companies without systematically affecting the broader market. The critical characteristic that makes unsystematic risk diversifiable is precisely this lack of correlation — because positive company-specific surprises at some holdings and negative surprises at others occur independently and in different directions, they partially cancel each other out in a diversified portfolio, reducing the portfolio's total volatility below the average volatility of its individual holdings.

The Mechanics of Diversification — How Unsystematic Risk Is Eliminated

The mathematical process through which diversification eliminates unsystematic risk is one of the most important results in all of portfolio theory — demonstrating precisely how and how quickly adding securities to a portfolio reduces total risk.

The foundational empirical research on this relationship is the 1968 study by John Evans and Stephen Archer — which measured how the standard deviation of an equity portfolio changes as the number of randomly selected stocks increases from one to many. Evans and Archer found that the relationship between portfolio size and portfolio standard deviation follows a characteristic pattern — very rapid risk reduction in the early stages of diversification and rapidly diminishing marginal risk reduction as the portfolio grows larger.

A portfolio consisting of a single stock has the full total risk of that stock — both its systematic and unsystematic components. Adding a second stock to the portfolio does not eliminate any systematic risk but reduces the unsystematic component significantly — because the second stock's company-specific volatility is uncorrelated with the first stock's and the two sources of idiosyncratic noise partially cancel. Adding a third, fourth, and fifth stock continues to reduce the unsystematic component. The reduction in unsystematic risk from adding each additional stock decreases as the portfolio grows — the first few additions produce dramatic risk reduction and later additions produce progressively smaller marginal improvements.

Academic research has generally found that a randomly selected portfolio of approximately twenty to thirty stocks in different industries eliminates the large majority of diversifiable unsystematic risk — leaving a residual standard deviation that approaches the market portfolio's systematic risk floor. Estimates of how many stocks are enough nonetheless differ: Meir Statman concluded in 1987 that a well-diversified portfolio of randomly chosen stocks must include at least thirty stocks for an investor who borrows and forty for one who lends, contradicting the widely accepted notion that the benefits of diversification are virtually exhausted once a portfolio holds about ten. A portfolio of the full S&P 500 constituents — roughly five hundred large-capitalisation companies — has essentially no remaining unsystematic risk because each company's weight in the portfolio is small enough that the contribution of its idiosyncratic volatility to total portfolio variance is negligible.

The irreducible residual volatility remaining after full diversification — the floor below which more stocks cannot push the portfolio's standard deviation — is entirely systematic risk. For a well-diversified United States equity portfolio this floor is approximately the volatility of the broad market itself, a figure that varies with the period over which it is measured — the irreducible volatility of being invested in the equity market at all, driven by the systematic forces of monetary policy, economic cycles, geopolitical events, and broad shifts in investor sentiment that affect all equities simultaneously.

Measuring Unsystematic Risk — Residual Variance and the Market Model

In practice unsystematic risk is measured with the market model, a regression of a security's periodic returns on the returns of a broad market index. The slope of the fitted line is the security's beta, and the part of each period's return that the line does not explain — the residual — is the company-specific component. The variance of those residuals is the security's unsystematic risk, while its systematic risk is beta squared multiplied by the variance of the market's return.

Because the residuals are by construction uncorrelated with the market's return, the two variances add up to the security's total variance — but their square roots, the standard deviations, do not. Consider a stock whose annualised standard deviation is thirty percent, with a beta of one point two against a market whose standard deviation is fifteen percent. Its systematic standard deviation is one point two times fifteen, or eighteen percent, and its systematic variance is 324 in squared percentage points. Its total variance is 900, so its unsystematic variance is 576 and its unsystematic standard deviation is twenty-four percent — not the twelve percent that subtracting eighteen from thirty would suggest.

The same arithmetic gives the share of total risk that is company-specific. The proportion of a security's return variance that the market explains is the R-squared of the regression, and the remainder, one minus R-squared, is the unsystematic share. In the example the market explains 324 of 900, an R-squared of thirty-six percent, so sixty-four percent of the stock's return variance is unsystematic — risk that holding the stock inside a broad portfolio would largely remove.

Diluting Unsystematic Risk — Why Position Weights Matter as Much as Their Number

The market model also shows how diversification acts on the unsystematic component. If the company-specific residuals of different holdings are uncorrelated with one another — the condition that makes the risk diversifiable — the unsystematic variance of a portfolio is the sum, across its holdings, of each holding's weight squared multiplied by that holding's residual variance. Squaring the weights is what makes dilution so effective: a holding that is one tenth of the portfolio contributes only one hundredth of its own residual variance.

For an equally weighted portfolio of holdings with similar residual variance, the portfolio's unsystematic variance is that residual variance divided by the number of holdings. Each doubling of the number of holdings therefore halves the unsystematic variance that remains. Moving from one stock to two removes half of a large quantity, while moving from twenty stocks to forty removes half of a quantity that is already small, which is why the curve of portfolio risk against portfolio size flattens so quickly.

The same formula shows why the number of holdings alone does not measure how much company-specific risk has been removed. A portfolio with half its value in one stock and the other half spread equally across fifty stocks holds fifty-one positions, yet the single large position by itself keeps one quarter of that stock's residual variance in the portfolio, and no number of small additional holdings can reduce that contribution. Where the holdings' residual variances are similar, the reciprocal of the sum of the squared weights gives the number of equally weighted holdings that would carry the same unsystematic risk — and for that portfolio it is fewer than four.

Has Company-Specific Risk Grown? — Evidence on Firm-Level Volatility

The amount of diversification an investor needs is not fixed, because the size of the company-specific component relative to the market component changes over time. A study by John Campbell, Martin Lettau, Burton Malkiel and Yexiao Xu, which separated the volatility of United States common stocks into market-level, industry-level and firm-level components over the period from 1962 to 1997, found a noticeable increase in firm-level volatility relative to market volatility across that period.

The study drew out the consequences for portfolios. As firm-level volatility rose relative to market volatility, the correlations among individual stocks declined, and so did the explanatory power of the market model for a typical stock — a larger share of each stock's movement was its own. At the same time the number of stocks needed to achieve a given level of diversification increased, because each holding carried more company-specific risk to be diluted. A rule of thumb about how many stocks make a diversified portfolio, drawn from the data of one period, can therefore understate what a later period requires.

The study also found that the market-level, industry-level and firm-level volatility measures move together countercyclically, rising when the economy weakens, and that market volatility tends to lead the other series. Company-specific risk is therefore not a constant background quantity that a fixed number of holdings removes once and for all: it tends to be elevated in the same difficult periods in which market-wide risk is also high.

The Sources of Unsystematic Risk — What Creates It

Understanding the specific sources of unsystematic risk — the types of company-specific and industry-specific events that constitute idiosyncratic risk — is essential for both examination purposes and for the practical risk analysis that investment advisers conduct when evaluating portfolios and making recommendations.

Business risk is the most fundamental source of unsystematic risk — the uncertainty inherent in a company's operating performance arising from the competitive dynamics of its industry, the quality and strategy of its management, the strength of its products and services, and its operational execution. A company that loses a major customer, whose flagship product fails in the market, whose new CEO makes poor strategic decisions, or whose manufacturing process produces defective goods faces business risk events that are entirely company-specific and uncorrelated with similar events at companies in different industries.

Financial risk is the unsystematic risk arising from a company's capital structure — particularly its use of financial leverage through debt financing. A highly leveraged company that experiences revenue pressure may face debt service difficulties and potential default — a company-specific financial risk that affects that issuer's bondholders and stockholders without systematically affecting investors in unlevered companies elsewhere in the market, although leverage also magnifies the sensitivity of a company's shares to market-wide movements and so raises their systematic risk as well. Credit rating downgrades, covenant violations, refinancing challenges, and liquidity crises are all financial risk events that are largely idiosyncratic to the specific issuer.

Regulatory and legal risk creates unsystematic exposure when a specific company or industry faces regulatory investigations, enforcement actions, litigation, or adverse legal rulings that affect its operations, costs, or competitive position without similarly affecting companies in unrelated industries. A pharmaceutical company facing an FDA enforcement action, a bank under investigation for anti-money-laundering violations, a technology company subject to antitrust scrutiny, or a manufacturer facing product liability litigation are all experiencing regulatory and legal risk that is largely unsystematic relative to the broad market.

Management risk is the unsystematic exposure created by the specific decisions, judgments, and competencies of a company's leadership team — whose quality, integrity, and strategic vision directly affect the company's performance in ways that are largely uncorrelated with the management decisions being made at other companies. An unexpected CEO departure, a management fraud discovery, a strategic acquisition that destroys shareholder value, or a succession failure that leaves the company without effective leadership are all management risk events that are idiosyncratic to the specific company.

Reputational risk — the damage to a company's brand, customer relationships, and social license to operate from specific events or revelations — is a significant and growing source of unsystematic risk in the modern information environment. A data privacy breach exposing millions of customers' personal information, a product safety scandal, an environmental incident, or a social media controversy can rapidly damage a company's reputation and financial performance in ways that are entirely company-specific and largely uncorrelated with competitors in the same or different industries.

The No-Compensation Principle — Why Unsystematic Risk Is Unpaid

The most examination-critical analytical implication of the unsystematic risk concept is the no-compensation principle — the CAPM prediction that investors receive no additional expected return for bearing unsystematic risk because they could eliminate it at no cost through diversification.

The logic is straightforward and compelling. Unsystematic risk is diversifiable — a rational investor can essentially eliminate it by holding a diversified portfolio of twenty to thirty or more stocks without sacrificing any expected return, because, in the model, spreading the same capital across many holdings in place of a few lowers risk while leaving expected return unchanged. Because the diversification is costless and the unsystematic risk can be eliminated at no cost, the market provides no risk premium for bearing it. An investor who chooses to hold a concentrated undiversified position — bearing substantial unsystematic risk — is making a voluntary choice to bear avoidable risk, and the market will not compensate them for this voluntary decision.

This no-compensation principle is the quantitative foundation for the recommendation that individual investors should hold diversified portfolios rather than concentrated positions in individual stocks. The investor who holds only one or two stocks bears the full unsystematic risk of those individual companies — a risk that adds volatility to the portfolio without adding expected return. This is genuinely bad portfolio construction from a risk-return perspective — the investor is bearing more risk than necessary to achieve a given level of expected return, or equivalently, earning less expected return than available for a given level of portfolio risk.

The practical implication for investment advisers under the fiduciary duty of the Investment Advisers Act of 1940 is that recommending or maintaining concentrated positions in individual stocks imposes avoidable unsystematic risk on clients without compensating expected return — and the adviser must have a reasonable belief, based on the client's objectives and evaluated in the context of the portfolio the adviser manages for the client, that advice to concentrate rather than diversify is in the client's best interest — the standard the Commission's 2019 interpretation of the adviser's duty of care applies to all advice.

Is Company-Specific Volatility Ever Rewarded? — The Idiosyncratic Volatility Puzzle

The no-compensation principle is a prediction of the Capital Asset Pricing Model, and researchers have tested whether stock returns actually behave that way. In a study first circulated in 2004, Andrew Ang, Robert Hodrick, Yuhang Xing and Xiaoyan Zhang measured each stock's idiosyncratic volatility not against the market alone but relative to the Fama and French three-factor model — the volatility left over once a stock's exposures to the market, size and value factors have been accounted for.

Their finding ran in the opposite direction to any reward for bearing company-specific risk: stocks with high idiosyncratic volatility relative to that model had abysmally low average returns. Nor was the pattern a disguised form of something already known. The authors reported that the low returns of the high-idiosyncratic-volatility stocks could not be explained by exposure to aggregate volatility risk, and that size, book-to-market, momentum and liquidity effects did not account for them either.

The same study separately examined a systematic exposure — each stock's sensitivity to innovations in aggregate market volatility — and found that stocks with high sensitivity to those innovations also had low average returns. The two results are distinct: one concerns how much a stock moves for reasons of its own, the other how it responds when volatility across the whole market rises. For examination purposes the theoretical principle is unchanged — the market pays no premium for diversifiable risk — but the evidence gives an investor no reason to expect that concentrating in highly volatile individual stocks will be rewarded with higher average returns.

Unsystematic Risk in Concentrated Portfolios — The Special Case

While the CAPM and Modern Portfolio Theory prescribe diversification to eliminate unsystematic risk, some sophisticated investors deliberately maintain concentrated undiversified portfolios based on specific investment theses — and understanding the analytical framework for evaluating concentrated portfolios is relevant to the Series 65 examination.

Concentrated portfolio investors — most famously Warren Buffett of Berkshire Hathaway — argue that deep fundamental research into a small number of businesses can justify holding them in concentration rather than diversifying. Buffett's own statement of the argument does not claim that concentration buys a higher return in exchange for more risk; it claims that, for an investor who genuinely understands the businesses held, concentration may lower risk, as the section on his 1993 letter explains.

The academic and empirical evidence on this debate is mixed — it has not established that concentrated managers as a group earn enough excess return to compensate their investors for the unsystematic risk they bear, nor shown in advance which concentrated investors will. The examination-relevant principle remains the theoretical foundation — unsystematic risk receives no compensation in the market equilibrium, and investors who bear it without a specific informational or analytical advantage are bearing unpaid risk.

The Concentrated Investor's Own Qualification — Buffett's 1993 Letter

Warren Buffett set out his case for concentration in his 1993 letter to Berkshire Hathaway shareholders, and the argument turns on how risk is defined. Buffett defined risk in its dictionary sense, as the possibility of loss or injury, and rejected the academic definition of risk as the volatility of a stock relative to a large universe of stocks, measured by beta. On his definition a policy of portfolio concentration may well decrease risk, if it raises both the intensity with which the investor thinks about a business and the comfort the investor must feel with its economic characteristics before buying into it.

The same letter identifies the circumstances in which wide diversification is required. Where a single commitment carries a significant possibility of loss, an investor may still undertake it if the probability-weighted gain considerably exceeds the probability-weighted loss, but only by making it one of many similar but mutually independent commitments, as an arbitrage programme or a venture capitalist does. Buffett compared that investor to a casino that wants plenty of action on its roulette wheel, where the odds favour it, but refuses to accept a single huge bet.

Buffett also distinguished between two kinds of investor. One who does not understand the economics of specific businesses but wishes to be a long-term owner of American industry should own a large number of equities and space out the purchases — for example by investing periodically in an index fund, which in his view lets such an investor outperform most investment professionals. Only for the investor able to understand business economics and to find five to ten sensibly priced companies with important long-term competitive advantages did he regard conventional diversification as making no sense.

Unsystematic Risk and the Sharpe Ratio Versus Treynor Ratio Choice

The distinction between systematic and unsystematic risk directly determines which risk-adjusted performance measure is most appropriate for evaluating a given portfolio — a connection directly tested on the Series 65 examination.

The Sharpe ratio uses total standard deviation — both systematic and unsystematic risk — as its risk denominator, making it the appropriate measure for evaluating the performance of a concentrated or undiversified portfolio where the investor is bearing substantial unsystematic risk that has not been diversified away. The Sharpe ratio appropriately penalises the concentrated portfolio for the full risk it imposes on the investor — both the systematic component that receives market compensation and the unsystematic component that does not.

The Treynor ratio uses beta — measuring only systematic risk — as its risk denominator, making it the appropriate measure for evaluating the performance of a well-diversified portfolio where unsystematic risk has been effectively eliminated. Since the well-diversified portfolio has essentially no unsystematic risk remaining, beta captures virtually all of its total risk and the Treynor ratio correctly measures performance per unit of the only risk the diversified portfolio actually bears.

Diversification as a Legal Duty — ERISA Plan Fiduciaries

For the fiduciaries of employee benefit plans, diversification is a statutory duty rather than only sound portfolio theory. Section 404(a)(1)(C) of the Employee Retirement Income Security Act of 1974 requires a plan fiduciary to discharge its duties by diversifying the investments of the plan so as to minimise the risk of large losses, unless under the circumstances it is clearly prudent not to do so. The duty stands beside, and separately from, the prudence requirement of Section 404(a)(1)(B), and diversification is the default from which a fiduciary may depart only where the circumstances make it clearly prudent to do so.

The statute makes one deliberate exception for concentration in the employer's own stock. In the case of an eligible individual account plan — a profit-sharing, stock bonus, thrift or savings plan, or an employee stock ownership plan — Section 404(a)(2) provides that the diversification requirement, and the prudence requirement only to the extent that it requires diversification, is not violated by the acquisition or holding of qualifying employer securities. A plan is treated as an eligible individual account plan for that purpose only if it explicitly provides for the acquisition and holding of qualifying employer securities.

The Supreme Court has confirmed how far the exception reaches. In Fifth Third Bancorp v. Dudenhoeffer in 2014 the Court held that fiduciaries of an employee stock ownership plan are not entitled to any special presumption of prudence. They are subject to the same duty of prudence that applies to ERISA fiduciaries in general, except that they need not diversify the fund's assets — so although they are not liable for losses that result from a failure to diversify, they remain subject to the duty of prudence in every other respect.

Employer Stock in Individual Account Plans — The Participant's Right to Diversify

Alongside that fiduciary exception, ERISA gives participants a right of their own to move out of employer stock. Section 204(j) applies to any individual account plan that holds publicly traded employer securities. For the portion of a participant's account attributable to employee contributions and elective deferrals that is invested in employer securities, the participant may direct the plan to divest those securities and reinvest an equivalent amount in other investment options, with no service requirement. For the portion attributable to employer contributions, the same right belongs to a participant who has completed at least three years of service, and to the beneficiary of such a participant or of a deceased participant.

The plan must offer at least three investment options other than employer securities to which divested amounts may be directed, each of them diversified and with materially different risk and return characteristics. A plan may confine divestment and reinvestment to periodic, reasonable opportunities occurring no less frequently than quarterly, but it may not impose restrictions or conditions on the investment of employer securities that it does not impose on the investment of other plan assets, apart from restrictions imposed by the securities laws.

Plans outside the eligible individual account category face a numerical limit instead. Under Section 407(a) of ERISA a plan may not acquire qualifying employer securities or qualifying employer real property if, immediately after the acquisition, the employer securities and employer real property it holds would exceed ten percent of the fair market value of its assets. Section 407(b) exempts eligible individual account plans from that limit, so it reaches a defined benefit pension plan but not a profit-sharing, savings or stock ownership plan that qualifies as an eligible individual account plan.

Unwinding Employer Stock From a Plan — Net Unrealized Appreciation

A participant whose plan account is concentrated in employer stock can reduce that concentration on leaving the plan, and the tax treatment of a distribution of employer securities shapes the choice. Net unrealized appreciation is the net increase in the value of the employer securities while they were held in the plan's trust. Under Section 402(e)(4) of the Internal Revenue Code, where employer securities are received as part of a lump-sum distribution, the net unrealized appreciation is excluded from gross income at the time of the distribution and the tax on it is deferred until the securities are sold or exchanged, unless the taxpayer elects to include it in income for the year of the distribution.

A lump-sum distribution for this purpose is the distribution or payment, within one taxable year of the recipient, of the participant's entire balance from all of the employer's qualified plans of one kind, paid because of the participant's death, after the participant reaches age 59 and a half, because the participant, if an employee, separates from service, or, for a self-employed individual, after the individual becomes totally and permanently disabled. Where a distribution is not a lump-sum distribution, the deferral is limited to the net unrealized appreciation attributable to the employee's own contributions, other than deductible voluntary employee contributions.

When the shares are later sold, any gain up to the amount of the deferred net unrealized appreciation is long-term capital gain, however briefly the shares were held after the distribution, and any gain beyond that amount is long-term or short-term according to how long the shares were held after the distribution. The participant's basis in the shares includes the employer's contributions attributable to them, which are taxed as ordinary income in the year of the distribution.

Pooling a Concentrated Position — The Investment Company Rule

An investor holding a large, highly appreciated position in one stock faces a dilemma: selling to diversify realises the gain and the tax on it, while holding keeps the unsystematic risk. One possible response is to contribute the shares to a partnership in exchange for an interest in a pool of many investors' shares. A contribution of property to a partnership is ordinarily free of tax under Section 721(a) of the Internal Revenue Code, but Section 721(b) removes that treatment for gain realised on a transfer to a partnership that would be treated as an investment company, within the meaning of Section 351, if the partnership were incorporated.

Under the Treasury regulations a transfer is a transfer to an investment company only if two conditions are both met. The transfer must result, directly or indirectly, in diversification of the transferors' interests, and the transferee must be a regulated investment company, a real estate investment trust, or an entity more than 80 percent of the value of whose assets is held for investment in stocks and securities — a category the Code defines broadly, counting money, debt instruments, options, futures and interests in real estate investment trusts and regulated investment companies among the stock and securities taken into account. A pool that does not meet the asset condition is not an investment company under the rule, however much the transferors' interests are diversified.

The diversification condition has its own rules. A transfer ordinarily results in diversification where two or more persons transfer nonidentical assets. Where there is only one transferor, or two or more transferors of identical assets, the transfer will generally be treated as not resulting in diversification, and transferors who each contribute a portfolio of stocks and securities that is already diversified are not treated as diversifying their interests.

Diversifying Through a Charitable Remainder Trust

A charitable remainder trust offers a further route to diversification for a holder of appreciated, concentrated stock who also intends a gift to charity. Under Section 664 of the Internal Revenue Code a charitable remainder annuity trust or charitable remainder unitrust is not subject to income tax for any taxable year, although any unrelated business taxable income draws an excise tax equal to that income. A trust that receives appreciated shares can therefore sell them and reinvest the proceeds in a diversified portfolio without itself paying income tax on the gain.

The gain is not forgiven but passes to the income beneficiary over time. Distributions take a fixed order of character in the beneficiary's hands: first as ordinary income, to the extent of the trust's ordinary income for the year and undistributed ordinary income of prior years; second as capital gain, to the extent of the trust's capital gain for the year and undistributed capital gain of prior years; third as other income, such as tax-exempt income; and only fourth as a distribution of trust corpus. Because the trust determines its undistributed capital gain on a cumulative net basis, the gain realised on selling the concentrated stock is carried out to the beneficiary as payments are made.

The trust must follow one of two payment patterns. An annuity trust pays a sum certain of not less than 5 percent nor more than 50 percent of the initial net fair market value of the property placed in trust; a unitrust pays a fixed percentage, within the same range, of the net fair market value of its assets valued annually. Either must pay at least annually, for the life or lives of individuals living when the trust is created or for a term of no more than 20 years, and the remainder interest passing to charity must be worth at least 10 percent of the net fair market value of the property placed in the trust.

Diversification Floors for Funds — The Regulated Investment Company Tests

The tax code builds a minimum level of diversification into the status of a regulated investment company. Under Section 851 of the Internal Revenue Code a fund must meet an asset test at the close of each quarter of its taxable year. At least 50 percent of the value of its total assets must be represented by cash and cash items, Government securities, securities of other regulated investment companies, and other securities limited, for each issuer, to no more than 5 percent of the value of the fund's total assets and no more than 10 percent of the issuer's outstanding voting securities.

A second limb caps concentration directly. Not more than 25 percent of the value of the fund's total assets may be invested in the securities of any one issuer, other than Government securities and the securities of other regulated investment companies, in the securities of two or more issuers that the fund controls and that are engaged in the same, similar or related trades or businesses, or in the securities of one or more qualified publicly traded partnerships. Because the tax test applies its per-issuer limits to only half of a fund's assets, where the Investment Company Act's definition of a diversified company applies the same limits to 75 percent, a fund can be non-diversified for securities law purposes and still meet the tax test.

The test is applied so that market movements alone do not cost a fund its status. A fund that met the requirements at the close of a quarter does not lose its status because of a later discrepancy between the value of its investments and the requirements, unless the discrepancy exists immediately after an acquisition and results wholly or partly from that acquisition. Even then the fund keeps its status for the quarter if the discrepancy is eliminated within 30 days after the close of the quarter.

Examination Relevance and Key Takeaways

Unsystematic risk is tested on the Series 65 examination in the context of Modern Portfolio Theory, total risk decomposition, the mechanics of diversification, the no-compensation principle, and the Sharpe ratio versus Treynor ratio choice.

The key points to retain are these.

Unsystematic risk — also called specific, idiosyncratic, diversifiable, or company-specific risk — is the component of total investment risk arising from factors unique to a specific company or industry that is uncorrelated across different holdings and therefore can be substantially eliminated through portfolio diversification. Total risk equals systematic risk plus unsystematic risk — systematic risk is the non-diversifiable market-wide component and unsystematic risk is the diversifiable company-specific component.

Diversification eliminates unsystematic risk through the statistical cancellation of independent company-specific events across a portfolio — positive idiosyncratic surprises at some holdings offset negative surprises at others, reducing total portfolio volatility below the average volatility of individual holdings. Research beginning with Evans and Archer showed that portfolio risk falls rapidly as the first stocks are added and ever more slowly thereafter, and a randomly selected portfolio of approximately twenty to thirty stocks in different industries eliminates the large majority of diversifiable unsystematic risk — the irreducible residual floor is entirely systematic risk — approximately the volatility of the broad market itself for a well-diversified United States equity portfolio.

The no-compensation principle — the foundational CAPM implication — is that investors receive no additional expected return for bearing unsystematic risk because diversification eliminates it at no cost. An investor bearing concentrated unsystematic risk is bearing avoidable unpaid risk — more volatility without more expected return. The primary sources of unsystematic risk are business risk from operating performance, financial risk from capital structure and leverage, regulatory and legal risk from company-specific enforcement or litigation, management risk from leadership quality and decisions, and reputational risk from company-specific events damaging brand and customer relationships.

The appropriate risk-adjusted performance measure for evaluating a concentrated undiversified portfolio is the Sharpe ratio — which uses total standard deviation capturing both systematic and unsystematic risk. The appropriate measure for a well-diversified portfolio is the Treynor ratio — which uses only beta capturing systematic risk since unsystematic risk has been eliminated through diversification.