The inherent risk involved in investing in a specific asset
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Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in investing in a specific asset, such as a stock. Idiosyncratic risk is the risk that is particular to a specific investment – as opposed to risk that affects the entire market or an entire investment portfolio. It is the opposite of systemic risk, which affects all investments within a given asset class. Systemic risks include things such as changing interest rates or inflation.
Idiosyncratic risks are rooted in individual companies (or individual investments). Investors can mitigate idiosyncratic risks by diversifying their investment portfolios.
Idiosyncratic Risk vs. Systemic Risk
With idiosyncratic risk, 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 overall market risk. The most effective way to mitigate or attempt to eliminate idiosyncratic risk is with the diversification of investments.
Idiosyncratic risk, by its very nature, is unpredictable. Studies show that most of the variation in risk that individual stocks face over time is created by idiosyncratic risk. If an investor is looking to cut down on the risk’s potentially drastic impact on his investment portfolio, he can accomplish this through investment tactics such as diversification and hedging. The diversification strategy involves investing in a variety of assets with low correlation – i.e., 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, thus hedging or minimizing his losses.
Systemic risk, on the other hand, involves macroeconomic factors that 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.
Common Forms of Idiosyncratic Risk
Every company and its stock face their own inherent risks. Some of the most common types of idiosyncratic risks include the choices a company’s management makes in relation to 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:
Systemic risks, in contrast, affect the entire market as a whole. They include taxation policies, inflation, interest rates, and economic growth or decline.
A Well-Publicized Example
In April 2018, LendingClub Corporation was accused by the Federal Trade Commission (FTC) of using deceptive practices with borrowers 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.
Both of the above events are examples of idiosyncratic risk – risks specific to a single company or stock, and not affecting 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.
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