Idiosyncratic Risk

Published Jan 1, 2023

Definition of Idiosyncratic Risk

Idiosyncratic risk is the risk that is specific to a particular asset (e.g., security or stock) or a specific group of assets (e.g., a certain sector). That means it describes the risk that is not shared by other assets but is individual to this particular asset or group of assets. It is caused by factors that are unique to the asset or group of assets in question and thus can be mitigated through portfolio diversification.

This type of risk is also known as unsystematic risk or specific risk. In that sense, it is the opposite of systematic risk, which describes the overall risk that affects all assets more or less equally.

Example

To illustrate this, let’s look at the example of two companies in the same sector: Company A and Company B. Both companies are in the same industry and have similar business models. However, Company A has recently been hit by a scandal involving its CEO, while Company B has not. As a result, Company A’s stock price has dropped significantly, while Company B’s stock price has remained relatively stable.

In this case, the risk associated with Company A’s stock is an idiosyncratic risk, because it is specific to that company (and its CEO) and not shared by other companies in the same sector, like company B.

Why Idiosyncratic Risk Matters

Idiosyncratic risk is an important concept in finance and financial economics because it can have a significant impact on the performance of a portfolio. That means investors need to be aware of the specific risks associated with their investments and take steps to mitigate them.

For example, investors can diversify their portfolios by investing in a variety of securities and companies in different sectors. This way, they can reduce the impact of idiosyncratic risk on their portfolios. In addition, investors can also use hedging strategies to reduce their exposure to unsystematic risk.