BAJAJ BROKING
March 12, 2025
1 mins read
An asset’s idiosyncratic risk is the risk that is specific due to its unique attributes. Hence, it is peculiar to the asset. Read more..Let us say that an auto manufacturer has to recall some of its cars due to a malfunctioning spare part. The risk of loss in this case falls in the category of idiosyncratic risk. As this risk is peculiar to an asset, it can be diversified and minimized by investing in a variety of assets, industries, markets, or geographies. Read less
The word “idiosyncratic” means “peculiar” or “distinctive.” If someone has an idiosyncrasy, it means it is peculiar to them. In the same vein, when an asset or a stock has idiosyncratic risk, it is due to factors specific to that asset. On the other hand, systematic risk is due to a large system. For example, if a company is based out of a politically unstable country, the risk it faces due to the instability of its location is a systematic risk, which is not due to a reason specific to it.
Read this blog, as it explains what idiosyncratic risk is with the help of examples and how it differs from systematic risk.
Idiosyncratic risk, also known as unsystematic risk, is specific to a certain asset. It is not due to the risk of the broader market. Instead, it is due to the unique attributes of a stock or any other kind of asset. This is why it is known as “idiosyncratic” because it is distinctive.
As it is idiosyncratic, investors can mitigate it by diversifying their portfolios. All securities, whether stocks, bonds, or any other kind of asset, exist in a certain market or an economy. Due to their presence in that market or economy, they carry a systematic risk, which cannot be diversified because it is due to the very market/economy they exist in.
However, all securities also have an idiosyncratic risk, which is on account of their unique attributes and hence can be diversified.
There are four main types of idiosyncratic risk, which are explained below:
a) Financial risk: All businesses have a unique risk, which is specific to their financial management. For example, they can have high debt levels or a low interest coverage ratio. Such financial risk, which is due to attributes specific to a business, is idiosyncratic in nature.
b) Business risk: A company can expose its investors to an idiosyncratic risk due to the unique nature of its business or something specific to its competitive landscape.
c) Operational risk: A business can expose you to risk on account of its operations. For example, its critical machinery can have a breakdown. Such risk also falls in the category of idiosyncratic risk, being unique to a business.
d) Regulatory risk: All businesses have to follow some sort of regulations. However, regulatory changes can adversely impact them by affecting their profits or cash flows, which is also a kind of idiosyncratic risk.
While idiosyncratic risk can be caused by a variety of reasons, the most common causes are explained below:
a) Company-specific issues: Issues specific to a company, like management changes, legal tussles, and product recalls, can affect its stock price, thereby causing idiosyncratic risk because they are peculiar to a company’s functioning.
b) Industry-specific events: If a certain industry-specific event affects a company’s performance, it can result in idiosyncratic risk, as it is unique to companies in that industry. Such industry-specific events can be due to regulatory changes, exchange rate fluctuations, or even technological disruptions.
c) Management and leadership: A company’s management and leadership can increase the risk of its business due to poor policy making. That said, a firm can also reduce its business risk due to the quality of its management.
d) Operational factors: Companies often face operational factors, like supply chain disruptions and production delays, which can affect their profitability and hence stock price. Such factors also result in idiosyncratic risk.
It is important to measure an asset’s idiosyncratic risk. Here are the metrics you can use to assess a stock’s idiosyncratic risk:
a) Differential in variance: You can measure a stock’s idiosyncratic risk by determining the difference between the variance in the stock’s returns and the variance in the market’s returns. The market’s variance represents the systematic risk, which cannot be diversified. The excess of a stock’s variance over the market’s variance is that stock’s idiosyncratic risk, which can be diversified.
b) Standard deviation: This indicator tells us the extent to which a stock’s returns deviate from the mean of its returns. The higher the standard deviation, the greater a stock’s idiosyncratic risk.
c) Correlation: To analyse how much a stock’s returns move with respect to the market’s returns, you can calculate the correlation coefficient between them.
d) Tracking error: This indicator assesses how consistent a stock’s returns are with respect to its benchmark. If the tracking error is high, it could indicate a high idiosyncratic risk.
If idiosyncratic risk is not managed well, it can adversely affect your portfolio, but you can minimize it by following these strategies:
a) Portfolio diversification: You can minimize idiosyncratic risk by diversifying your portfolio by investing in a variety of stocks, assets, and securities. As idiosyncratic risk is specific to an asset, if an asset’s performance suffers, it is unlikely that the same reason will cause the performance of another asset to suffer as well. Hence, diversification can help you mitigate idiosyncratic risk.
b) Hedging: You can reduce a stock’s idiosyncratic risk by taking an opposite position in the same stock or a related stock, which helps you offset potential losses. It is called hedging; investors have used it for centuries to reduce idiosyncratic risk.
The following table explains the key differences between idiosyncratic risk and systematic risk. So, read on…
Criteria | Idiosyncratic Risk | Systematic Risk |
Meaning | An asset’s risk that is unique due to its attributes is called idiosyncratic risk. | When an asset exposes you to risk on account of its presence in a larger economy or market, it is called systematic risk. |
Whether it is diversifiable | As idiosyncratic risk is specific to an asset, you can diversify it by investing in other assets. | Systematic risk is due to a larger economy or market. In other words, it is due to the very presence of an asset in a market or an economy. Hence, it cannot be diversified. |
What kind of assets does it affect? | Although all assets can have a certain degree of idiosyncratic risk, some assets have it more than others. | All assets are affected by systematic risk. |
How to mitigate it? | You can mitigate idiosyncratic risk through diversification and hedging. | You can use risk management strategies and asset allocation techniques to reduce systematic risk. |
Examples | Business risk, financial risk, & operational risk are some of its examples. | Market risk and interest rate risk are some of its examples. |
Let us take some examples of idiosyncratic risk to understand the concept better. Suppose a pharmaceutical company’s factory goes through an inspection by regulatory authorities, which reveals that some of its drugs are not safe for human consumption.
As a result, the authorities order the company to stop manufacturing in the factory. This event is specific to the concerned company. Hence, the potential loss of reputation and money falls in the category of idiosyncratic risk.
Now, suppose a bank extends a large loan to a multinational corporation, but its officials cannot correctly assess the creditworthiness of the borrower. Subsequently, the borrower fails to pay the loan. The loan goes bad due to the incompetence of the bank’s officials. Hence, it poses an idiosyncratic risk.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Idiosyncratic risk is due to factors unique to a stock; hence, it is diversifiable. On the other hand, systematic risk is due to a larger economy and market; hence, it is not diversifiable.
By spreading investments across several asset classes, geographies, industries, and markets, diversification helps you reduce idiosyncratic risk.
No, idiosyncratic risk cannot be totally eliminated. However, it can be minimized by investing in a variety of assets, markets, industries, and geographies.
Risks specific to a business on account of the very nature of its operations, financing, and technology are examples of idiosyncratic risk.
Company-specific events, such as product recalls, factory shutdowns, and management changes, can increase or decrease the idiosyncratic risk of a stock.
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