What Is Idiosyncratic Risk?
Idiosyncratic risk is a type of investment risk that is specific to an individual asset like a particular company’s stock. It can also affect a group of related assets like a particular sector’s stocks. And, in some cases, a very specific asset class like collateralized mortgage obligations. Idiosyncratic risk is also referred to as a specific risk or unsystematic risk. This type of risk is rooted in individual companies or individual investments. Therefore, idiosyncratic risk can generally be mitigated in an investment portfolio through the use of diversification.
The opposite of idiosyncratic risk is a systematic risk. Systematic risk is the overall risk that affects all assets in the entire financial system. This could be due to fluctuations in the stock market, interest rates, or the entire economy. It refers to broader trends that impact the overall financial system or a very broad market.
Idiosyncratic Risk – A Closer Look
According to research, idiosyncratic risk accounts for most of the variance in individual stock price. Over time, this uncertainty affects individual stocks more than the overall market risk. Idiosyncratic risk is often described as the microeconomic factors affecting an asset like the stock and its underlying business. It has little or no risk association representing greater macroeconomic factors, such as market risk. Microeconomic influences are those that affect a small or restricted portion of the economy. Macroeconomic forces are those that affect broader segments of the economy as a whole.
The decisions made by the company management on financial policy, investment strategy, and operations are all idiosyncratic risks unique to a specific company and stock. Certain examples may include the geographic location and corporate culture of the operations. For example, consider a mining company. The depletion of a vein or a seam of ore would be an example of idiosyncratic risk for mining companies. Similarly, the threat of strikes by pilots or flight attendants would be examples of idiosyncratic risk to airline companies. (Source: cleartax.in)
Idiosyncratic Risk vs. Systematic Risk
Idiosyncratic risk is, by definition, irregular and unpredictable. Studying a company or industry can help an investor to identify and anticipate its potential idiosyncratic risks. This risk is often highly individual, even unique in some cases. It can, therefore, be substantially mitigated or eliminated from a portfolio by using adequate diversification. Proper asset allocation, along with hedging strategies, can minimize its negative impact on an investment portfolio. Factors that affect assets such as stocks and the companies underlying them, make an impact on a microeconomic level. This means that idiosyncratic risk shows little if any, correlation to broader, overall market risk. Therefore, the most effective way to reduce idiosyncratic risk is with the diversification of investments.
Studies show that most of the variation in risk that individual stocks face over time is created by idiosyncratic risk. Tactics such as diversification and hedging can greatly reduce this type of specific, individual risk. Diversification involves investing in a variety of assets with low correlation. Those are assets that don’t typically move together in the market. The theory behind diversification is that when one or more assets lose money, the rest of an investor’s non-correlated investments gain. The result is hedging or minimizing the losses of the portfolio as a whole.
In contrast, systematic risk cannot be mitigated just by adding more assets to an investment portfolio. Over-all market risk cannot be eliminated just by adding stocks of various sectors to a portfolio. Systemic risk involves macroeconomic factors. These factors affect not just one investment, but the overall market and economy in general. Adding more assets to a portfolio or diversifying the assets within it cannot counteract systemic risk. These broader types of risk affect other assets and greater markets and economies as well.
Common Forms of Idiosyncratic Risk
Every company faces its own inherent risks. Some of the most common types of idiosyncratic risks include the everyday choices a company’s management makes. For example, operating strategies, financial policies, and investment strategy. Other forms of regularly recurring idiosyncratic risk include the general culture and strength of the company from within, and where its operations are based. Factors of idiosyncratic risk:
- Operating Strategies
- Policies – Financial policies
- Culture – Corporate culture
- Investment strategies
This is in contrast to systemic risks which affect the entire market as a whole. They include taxation policies, inflation, interest rates, and economic growth or decline.
Examples of Idiosyncratic Risk
In the energy sector, there are stocks of companies that own or operate oil pipelines. They face an idiosyncratic risk that is particular to their industry. For example, their pipelines may become damaged, leak oil, and bring about repair expenses. This could escalate into lawsuits and fines from government agencies. As a result, a company may be forced to decrease distributions to investors and declining share prices.
Another example of idiosyncratic risk is a company’s dependence on a charismatic CEO. For example, during its breakout success in the 2000s, Apple Inc. (AAPL) was synonymous with its co-founder, Steve Jobs. When Jobs fell ill and took a leave of absence from the company in 2010, Apple’s stock continued to appreciate in absolute terms, but its valuation relative to price multiples fell. Jobs took another leave in early 2011. He resigned as CEO in August and passing away in October. Apple’s stock traded lower—briefly. Jobs was known for being a visionary and turning around Apple. As such, his leadership was part of Apple’s success and its stock price. Ultimately, faith in the company and its products prevailed, and Apple stock recovered to reach new highs through early 2020. (Source: investopedia.com)
A Real-life Example
In April 2018, LendingClub Corporation was accused by the Federal Trade Commission (FTC) of using deceptive practices with borrowers. This was in regard to fees and also with debiting money from customer accounts without authorization. The market reaction was swift, dropping LendingClub (NYSE: LC) shares by 15% in short order. This event followed troubles for the company in 2016 surrounding the departure of CEO Renaud Laplanche. (Source: corporatefinanceinstitute.com)
Why Does Idiosyncratic Risk Matter?
Some of the factors that affect investments have little to do with the actual investment choice. As a result, these systematic risks are borne by all investors. Therefore, systematic risks are what influence asset allocation. Idiosyncratic risk is what influences individual stock picking. Diversification can mitigate idiosyncratic risk. That is, an investor can buy stocks that don’t move together. As a result, some will rise when others fall. However, diversification generally cannot mitigate market-wide, systematic risk.
Idiosyncratic risk is specific to a single company or stock. But, does not affect the market as a whole nor the overall industry in which the company operates. Every investment inherently carries risk. Understanding the various risks associated with an investment, both systemic and idiosyncratic, is important in helping investors plan their investment portfolios wisely.
Day trading can be summarized simply as buying security. Then, quickly selling or closing out the position within a single trading day. Ideally, day traders want to “cash-out” by the end of each day with no open positions This lets them avoid the risk of losses by holding security overnight. Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term. Short-term profits require a very different approach compared to traditional long-term, buy and hold investment strategies.