What Is Idiosyncratic Risk?
Idiosyncratic risk is a type of investment risk that is endemic to an individual asset (like a particular company's stock), a group of assets (like a particular sector), or 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.
Therefore, the opposite of idiosyncratic risk is a systematic risk, which is the overall risk that affects all assets, such as fluctuations in the stock market, interest rates, or the entire financial system.
- Idiosyncratic risk refers to the inherent factors that can negatively impact individual securities or a very specific group of assets.
- It is also known as specific, or unsystematic risk.
- Certain securities will naturally have more idiosyncratic risk than others.
- Idiosyncratic risk can generally be mitigated in an investment portfolio through the use of diversification.
- The opposite of Idiosyncratic risk is a systematic risk, which refers to broader trends that impact the overall financial system or a very broad market.
Understanding Idiosyncratic Risk
Research suggests that idiosyncratic risk accounts for most of the variation in the uncertainty surrounding an individual stock over time, rather than market risk. Idiosyncratic risk can be thought of as the factors that affect an asset such as the stock and its underlying company at the microeconomic level. It has little or no correlation with risks that reflect larger macroeconomic forces, such as market risk. Microeconomic factors are those that affect a limited or small portion of the entire economy, and macro forces are those impacting larger segments or the entire economy.
Company management's decisions on financial policy, investment strategy, and operations are all idiosyncratic risks specific to a particular company and stock. Other examples can include the geographical location of operations and corporate culture. In terms of industry or sector, an example of idiosyncratic risk for mining companies would be the exhaustion or the inaccessibility of a vein or a seam of metal. Likewise, the possibility of a pilots' or a mechanics' strike would be an idiosyncratic risk for airline companies.
- Business risk is an idiosyncratic risk associated with the nature of a business along with its competitive landscape and market.
- Operational risk arises when, for example, a machine breaks down, a factory catches fire, or a key employee dies.
- Financial risk relates to a particular company's capital structure and financial exposures.
- Regulatory/legal risk has to do with the possibility of new laws or regulations that can harm a firm's bottom line or ability to operate freely.
Idiosyncratic Risk vs. Systematic Risk
Idiosyncratic risk is inherent in any individual company or investment. This is because every company has its own specific strengths and weaknesses, competitive landscape, management style, external threats, and so on. Thus the business risk for any one company will be largely unique.
However, there are also market-wide risks that are inherent in most every security in a certain asset class, stemming largely from macroeconomic considerations. This is known as systematic risk or market risk. Thus, in contrast to idiosyncratic risk, systematic risk cannot be simply mitigated just by adding more assets to an investment portfolio that can counteract the specific risks of certain stocks. This market-wide risk cannot be eliminated by adding stocks of various sectors to one's holdings. These broader types of risk reflect the macroeconomic factors that affect not just a single asset but other assets like it and greater markets and economies as well.
Strategies for Minimizing Idiosyncratic Risk
While idiosyncratic risk is, by definition, irregular and unpredictable, studying a company or industry can help an investor to identify and anticipate—in a general way—its idiosyncratic risks. Idiosyncratic risk is also 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 by diversification or hedging.
Diversification works because the specific risk of one company will likely not be the same as other companies. So, if one company in one sector experiences a product recall (say it is a car company), it likely won't influence the price of an apparel company or a restaurant stock. The best way to diversify is to hold stocks, therefore, that are largely uncorrelated with one another. Another diversification strategy is to buy the overall index, such as the S&P 500, using a mutual fund or ETF. This is a low-cost way to ensure a well-diversified portfolio.
Hedging is a strategy that takes an offsetting position in a similar security. This can be done, for instance, using options contracts. A put grants the right, but not the obligation to sell the underlying stock at a set price. So, if you own stock in the automaker, you can buy a protective put that will establish a price floor for you until the contract expires. Hedging, however, requires an outlay of cash since you need to buy the options, but you can also think of it like buying insurance on your holdings.
Examples of Idiosyncratic Risk
Energy Stocks: Industry-Specific Risk
In the energy sector, the stocks of companies that own or operate oil pipelines face a sort of idiosyncratic risk that's particular to their industry—that their pipelines may become damaged, leak oil, and bring about repair expenses, lawsuits, and fines from government agencies. Unfortunate circumstances like these may cause a company such as Kinder Morgan, Inc. (KMI) or Enbridge, Inc. (ENB), to decrease distributions to investors and cause the shares to fall in price.
Apple: The Role of a Charismatic Leader
Another example of idiosyncratic risk is a company's dependence on the CEO. For much of its history, and certainly, 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.
After Jobs took another leave in early 2011, resigning 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.
CoinBase: Tied to a Unique Asset Class
CoinBase (COIN) is the largest North American cryptocurrency exchange and has made a reputation for itself as being legitimate and trustworthy. Still, its stock price is largely tied to that of the crypto market. This is an idiosyncratic risk. In the Spring of 2022, when the crypto market experienced a severe correction, the price of COIN stock also suffered.
What Are Types of Idiosyncratic Risk?
While each company will have its own idiosyncratic risk profile, these can generally be categorized into one or more of the following: business risk; financial risk; operational risk; strategic risk; and legal or regulatory risk.
How Is Idiosyncratic Risk Measured?
Idiosyncratic risk can be measured for a stock as its variance in excess of the systematic risk observed in the market. In other words, the difference between a stock's variance and the market's variance.
Is Beta the Same As Idiosyncratic Risk?
A stock's beta estimates its volatility in reference to the S&P 500. In that respect, it might be seen as a measure of idiosyncratic risk. However, this is mistaken. Beta is actually a measure of a stock's contribution to overall systematic risk and is arrived at using the capital asset pricing model (CAPM).