Residual risk is a concept in economics. It has meanings in both the general economy and financial sectors. Basically, it refers to unknown risk: the risk that is left over when other risks are taken into account. In finance, it has the narrower meaning of risk that is specific to an individual stock rather than a product of market conditions. The financial application of the term has many other names, including unsystematic risk, non-systematic risk, specific risk, diversifiable risk and unhedgeable risk.
In non-financial situations, residual risk is the unknown. For example, if a company has to make a large delivery, then there is some probability that something will happen to disrupt the delivery, costing the company the price of the goods. The total risk that applies to the situation is called the inherent risk. The company will then take actions to reduce the risk: update the packing process to prevent spoilage, hire additional drivers so they can switch off and avoid fatigue, or reroute the delivery along safer roads, for example. The unforeseen risk that the company cannot account for, like an unexpected blizzard that shuts down roads, is the residual risk &emdash; it is any danger that is not included in the risk assessment.
In finance, residual risk is the volatility of a stock once prices are controlled for general market movement. The idea is that the total risk of a stock 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, may be separated out by taking actions 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 stock and cannot be hedged remains.
Financial residual risk, unlike that of non-financial sectors, can be accounted for through portfolio composition, which gives it the name “diversifiable risk.” Investors are frequently advised to diversify their portfolios, and this is because diversifying reduces residual risk. Stocks do not move together perfectly, and investors can use those variations in movement. The probability of one asset’s value going down is partially canceled out by the probability of another asset’s value going up; the more assets in a portfolio, the smaller the probability that their prices will all fall more quickly than the market. This canceling of risk means that an investor can combine assets to achieve a portfolio with the same expected return that he would have had with a single asset at a lower risk.
