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.
BREAKING DOWN 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.
Systematic risk is the macroeconomic factors that affect not just a single asset but other assets like it and greater markets and economies as well. Systematic risk cannot be eliminated by adding more and more assets to a portfolio. For example, market risk cannot be eliminated by adding stocks of various sectors to an investment portfolio regardless of their number.
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.
Another example of idiosyncratic risk is a company's dependence on the CEO. When Apple CEO and co-founder, Steve Jobs, fell ill and took a leave of absence from the company, Apple's stock continued to appreciate in absolute terms, but its valuation relative to price multiples fell. After Jobs passed away, Apple's stock traded lower. Jobs was known for being a visionary and turning around Apple; as such, his leadership was part of Apple's success and ultimately its stock price.
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.