What is ‘Idiosyncratic Risk’
Idiosyncratic risk, also referred to as unsystematic risk, is the risk that is endemic to a particular asset such as a stock and not a whole investment portfolio. Being the opposite of systematic risk (the overall risk that affects all assets like fluctuations in the stock market or interest rates), Idiosyncratic risk can be mitigated through diversification in an investment portfolio.
Explaining ‘Idiosyncratic Risk’
Idiosyncratic risk can be thought of as the factors that affect an asset such as a stock and its underlying company at the microeconomic level. Idiosyncratic risk has little or no correlation with market risk, and can therefore be substantially mitigated or eliminated from a portfolio by using adequate diversification. Research suggests that idiosyncratic risk accounts for most of the variation in the risk of an individual stock over time rather than market risk. Since idiosyncratic risk is by definition generally unpredictable, investors seek to minimize its negative impact on an investment portfolio by diversification or hedging.
Examples of Idiosyncratic Risk
All pipeline companies, and their stocks, face the idiosyncratic risk that their pipelines may become damaged, leak oil and bring about repair expenses, lawsuits or fines from government agencies. Unfortunate circumstances like these may cause the company to decrease distributions to investors and cause the stock to fall in price. The risk of a pipeline company incurring massive damages because of an oil spill can be mitigated by investing in a broad cross-section of stocks within the portfolio. A macroeconomic factor, however, cannot be diversified away as it affects not only pipeline stocks but all stocks. If interest rates rise, for example, the value of a pipeline company’s stock will likely fall in line with all other stocks. That is systematic risk.
Common Idiosyncratic Risks
Company management’s decisions on financial policy, investment policy and operations are all idiosyncratic risks specific to a particular company and stock. Other examples can include location of operations and company culture. In contrast, nonidiosyncratic risks may include interest rates, inflation, economic growth or tax policy.
Further Reading
- Costly arbitrage and the myth of idiosyncratic risk – www.sciencedirect.com [PDF]
- Uninsured idiosyncratic risk and aggregate saving – academic.oup.com [PDF]
- Idiosyncratic risk and the cross-section of expected stock returns – www.sciencedirect.com [PDF]
- Asset pricing with idiosyncratic risk and overlapping generations – www.sciencedirect.com [PDF]
- Can growth options explain the trend in idiosyncratic risk? – academic.oup.com [PDF]
- Return reversals, idiosyncratic risk, and expected returns – academic.oup.com [PDF]
- Positive and negative corporate social responsibility, financial leverage, and idiosyncratic risk – link.springer.com [PDF]
- Idiosyncratic risk matters! – onlinelibrary.wiley.com [PDF]
