What does firm-specific risk relate to?

Firm-specific risk pertains to the types of risks that are unique to an individual company or organization. This type of risk can arise from a variety of factors, such as management decisions, product recalls, or operational issues specific to that firm. The key aspect of firm-specific risk is that it can often be mitigated or reduced through diversification. When investors spread their investments across a range of different assets or firms, they can minimize the impact of adverse events affecting a single company, thereby reducing their exposure to that firm's specific risks.

This contrasts with other types of risks, such as market-wide economic downturns or legal regulations that impact all firms, which are not specific to any single company and cannot be diversified away. Similarly, global trade disputes might affect many companies but are not tied to a specific firm's internal factors. Therefore, diversification serves as an effective strategy to mitigate firm-specific risk, isolating the broader market or external factors that investors must contend with.