Residual risk is an unknown risk that remains when other risks are taken into consideration. In finance, it refers to risk specific to an individual security. Diversification reduces residual risk, making it less likely for prices to fall faster than the market.
Residual risk is a concept in economics. It has meanings in both the general economy and the financial sectors. Basically, it refers to an unknown risk: the risk that remains when other risks are taken into consideration. In the financial sector, it has the narrower meaning of risk specific to an individual security rather than a product of market conditions. The financial application of the term has many other denominations, including unsystematic risk, unsystematic risk, specific risk, diversifiable risk and unhedged risk.
In non-financial situations, the residual risk is the unknown. For example, if a business has a large delivery to make, something is likely to happen that disrupts the delivery, costing the business the price of the goods. The total risk that applies to the situation is called inherent risk. The company will then take actions to reduce the risk: upgrade the packaging process to prevent spoilage, hire additional drivers so they can switch off and avoid fatigue, or reroute delivery along safer routes, for example. The unforeseen risk that society cannot account for, such as an unexpected blizzard that closes the roads, is the residual risk &emdash; it is a hazard that is not included in the risk assessment.
In the financial sector, residual risk is the volatility of a security once prices are controlled for general market movement. The idea is that a stock’s total risk is composed of two factors: the ups and downs of the economy as a whole and the fluctuations caused by the actions of the individual firm. Market risk, or systematic risk, can be separated by taking steps to hedge the risk, such as trading in the futures market. Once market risks are accounted for, only the risk that is specific to the security remains and cannot be hedged.
The residual financial risk, unlike that of the non-financial sectors, can be accounted for through the composition of the portfolio, which gives it the name of “diversifiable risk”. Investors are often advised to diversify their portfolios, and this is because diversification reduces residual risk. Stocks don’t move perfectly together and investors can use those variations in movements. The probability that the value of one asset will decrease is partially canceled out by the probability that the value of another asset will increase; the more assets in a portfolio, the less likely their prices are to fall faster than the market. This cancellation of risk means that an investor can combine assets to obtain a portfolio with the same expected return as he would have with a single lower risk asset.
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