Loading the player...

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.

RELATED TERMS
  1. Market Risk

    Market risk is the possibility of an investor experiencing losses ...
  2. Diversified Fund

    A diversified fund is a fund that is broadly diversified across ...
  3. Company Risk

    Company risk is the financial uncertainty faced by an investor ...
  4. Price Risk

    The risk of a decline in the value of a security or a portfolio. ...
  5. Operational Risk

    Operational risk summarizes the risks a company undertakes when ...
  6. Risk Profile

    An evaluation of an individual or organization's willingness ...
Related Articles
  1. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  2. Financial Advisor

    Why Liquidity Matters in the Corporate Bond Market

    Professional analysis and constant monitoring of liquidity risk when investing in corporate bonds is highly important.
  3. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
  4. Investing

    How to Diversify Your Portfolio Beyond Stocks

    Find out how to get diversified in asset classes beyond stocks to reduce portfolio risk. Learn how diversification can help you reach your financial goals.
  5. Financial Advisor

    Active Risk vs. Residual Risk: Differences and Examples

    Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
  6. Investing

    Diversification: The Right Way to Manage Risk

    Diversifying your portfolio across multiple asset classes will help you minimize investment risk.
  7. Investing

    Balancing the Different Risks Investors Face

    One of the keys to investing successfully is to balance different types of risk.
  8. Investing

    Currency ETFs Simplify Forex Trades

    Reduce your stock portfolio's risk by trading with foreign currencies.
  9. Investing

    The Dangers Of Over-Diversifying Your Portfolio

    If you over-diversify your portfolio, you might not lose much, but you won't gain much either. Find out how to maintain a well-balanced set of investments.
RELATED FAQS
  1. Systemic versus systematic risk: What's the difference?

    Systemic risk generally refers to an event that can trigger a collapse in a certain industry or economy, whereas systematic ... Read Answer >>
  2. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
  3. Financial Risk vs Business Risk

    Understand the key differences between a company's financial risk and its business risk – along with some of the factors ... Read Answer >>
  4. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
  5. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
Hot Definitions
  1. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  2. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  3. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  4. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  5. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  6. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
Trading Center