Idiosyncratic Risk Meaning
Idiosyncratic risk arises from variables or conditions that impact the value of a single, multiple, or rare asset of a particular company or sector over time rather than market risk. It is inherent with individual investment and does not affect the total investment portfolio of an investor.
Idiosyncratic risk, also known as unsystematic riskUnsystematic RiskUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole. There are two types of unsystematic risk: business risk and financial risk. or diversifiable riskDiversifiable RiskA diversifiable risk refers to the firm-specific uncertainty that impacts an individual stock price rather than affecting the whole industry or sector in which the firm operates. Such risk can be mitigated or reduced by adopting diversification strategies to ensure that the returns are not affected., is highly unexpected and irregular. Examples include management decisions, legislative changes, competition, product recalls, etc. Investments strategiesInvestments StrategiesInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on. like portfolio diversification and hedging can help mitigate the risk. It differs from systematic risk, which impacts all assets and the overall market or sector.
Table of contents
- Idiosyncratic risk emerges from variables or events that impact the value of a single, multiple, or rare asset of a company or industry over time.
- It is highly unpredictable, irregular, and inherent in individual investments, with little bearing on an investor’s overall portfolio.
- Portfolio diversification, hedging, strategic investment, and the study of the business or sector can help reduce the risk.
- Unsystematic risk is not the same as systematic risk, which occurs at the macroeconomic level and affects all assets and the entire market or industry.
Understanding Idiosyncratic Risk
Idiosyncratic risk definition refers to a type of risk limited to individual investments in an asset or a group of assets of a particular corporation or industry. It is not, however, tied to general market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.. Instead, it is linked to unforeseen and uncertain circumstances surrounding a business or sector that affect asset prices. Also, it occurs at the microeconomic level rather than the macroeconomic level and has little impact on the overall economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.. Short-term stock price fluctuations indicate this type of risk.
Idiosyncratic risk can result from new market rivalry, business news, rumors, strike, change in investment policies, strategies, interest rates, operations, culture, legal procedures, supply and demand chain failure, or inventory shortages of a company or sector. Individual investors usually face this risk due to microeconomic forces causing a price variation in the asset(s) and underlying business.
While every investor is prone to systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”., idiosyncratic risk is exclusive to a particular company or industry. Therefore, experts suggest investors diversify or hedge their portfolios and make strategic investment decisions to avoid the risk. Besides, they should not aggressively invest in a single asset or group of assets. Another pro advice is to analyze the business or sector to anticipate the risk and its negative impact on the investment portfolio. Investors can calculate unsystematic risk by deducting the systematic risk from the total risk.
Idiosyncratic Risk Examples
Let us look at the following examples to understand the concept even better:
Simon has invested in the stocks of three separate companies – a fast moving consumer goods companyFast Moving Consumer Goods CompanyFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc., an automobile company, and a bank. They are all part of three different industries. Everything was going well, and Simon was enjoying his balanced investment portfolio.
One day, laborers of the automotive firm, stocks of which, Simon owned went on an indefinite strike for some reason. It led to a substantial decline in automobile production and sales. As the news of the strike spread, the company stock prices started to decline for a week before stabilizing in a price range, thus bringing loss to Simon.
It is clear from this example that the idiosyncratic risk only affected the automobile company and its stocks, not the entire market or sector.
Another idiosyncratic risk example is the largest oil spill in the history of oil drilling. On April 20, 2010, the oil drilling rig Deepwater Horizon, operated by BP PLC on the Macondo Prospect in the Gulf of Mexico, exploded and sank. Following the explosion, the oil continued to flow in the seawater until it was capped on July 15, 2010. As a result, the unsystematic risk that happened during those 87 days had a detrimental impact on the company’s stock values rather than the whole market or industry.
Idiosyncratic Risk vs Systematic Risk
An example of each can help understand the distinction between idiosyncratic and systematic risk:
Assume there is a smartphone firm that has a global monopoly. Suddenly, the company’s sales plummet due to a new competitor entering the market that offers the same sort and quality of mobile phones at a lower price. Eventually, it results in a decline in the company’s stock prices. It is a simple idiosyncratic risk example.
The COVID-19 pandemic had a significant impact on many global economies. People lost their employment, most companies went out of business, and schools and universities closed permanently. All of this had an impact on all stock exchanges and overall financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.. It resulted in the 2020 stock market crisis, which lasted almost a couple of months. It is a good illustration of systematic risk.
Here are a few key differences that distinguish idiosyncratic risk from systematic risk:
|Affects the asset prices of a particular company or sector
|Impacts all assets and causes fluctuation in the broader markets
|Examples include market rivalry and business news, strike, change in investment policies, strategies, interest rates, operations, laws about a company or sector
|Includes variation in stock prices, recession, inflation, market correction, taxation policy, and change of interest rates
|Inherent with individual investment in the asset or the security
|Affects the entire investment portfolio consisting of several securities
|Occurs at the microeconomic level
|Occurs at the macroeconomic level
|Diversification, hedging, and careful business or industry analysis can mitigate the risk
|Portfolio diversification cannot minimize the risk
Frequently Asked Questions (FAQs)
Idiosyncratic risk is associated with the individual investment in an asset or a group of assets of a specific firm or industry. It is not, however, linked to the overall market risk. Instead, it is connected with unforeseen and unknown conditions that affect asset prices surrounding a business or industry. New market rivalry, business news, rumors, strikes, changes in investment policies, strategies, interest rates, laws in a company or industry, and product recalls are all examples of it.
Though investors can calculate unsystematic risk by subtracting systematic risk from total risk, there is no idiosyncratic risk formula.
Individual investors typically experience this risk due to microeconomic dynamics that cause price fluctuations in the asset(s) and underlying business. Portfolio diversification, hedging, strategic investments, planned asset allocation, and knowledge of the firm or sector can help investors mitigate the idiosyncratic risk.
This has been a guide to what is Idiosyncratic Risk & its Meaning. Here we discuss how to reduce idiosyncratic risk and examples along with idiosyncratic risk vs systematic risk. You can learn more about Investment Banking from the following articles –