What is Idiosyncratic Risk?
Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in investing in a specific asset – such as a stock – the risk that doesn’t affect the entire market or an entire investment portfolio. It is the opposite of systemic risk, which affects all assets. Systemic risks include things such as changing interest rates or inflation.
Idiosyncratic risks are more 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. It 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 diversification.
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 it through investment tactics such as diversification and hedging. The 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 his losses.
Systemic risk, on the other hand, involves macroeconomic factors that affect not just one asset, but most assets, as well as the market and various economies 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 risk 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.
Types of idiosyncratic risk:
- Operating strategies
- Financial policies
- Corporate culture
- Investment strategy
Non-idiosyncratic 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 of Idiosyncratic Risk
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 debiting money from their bank accounts without authorization. The market reaction was swift, dropping LendingClub (NYSE: LC) shares by 15%. It 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 asset carries inherent risk. Understanding the various risks associated with an asset, both systemic risks, and idiosyncratic risks, is important in helping investors plan their investment portfolios wisely.
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