What is Idiosyncratic Risk?
In the concept of Idiosyncratic Risk, the investors can decrease, or even eliminate, the level of company-specific risk in any individual share by owning a sufficiently broad, diversified portfolio. It refers to the underlying reasons that can negatively influence single security or a small group of assets. Systematic risk is the opposite of idiosyncratic risk, and it relates to more prominent tendencies that affect the entire financial system or a vast market.
Example of Idiosyncratic Risk:
Accounting fraud, cyberattacks, loss of key personnel, or any other issue which affects a specific company without affecting the rest of the market.
Following are how idiosyncratic risks can be avoided:
- Holding a well-diversified portfolio reduces the impact of events on individual companies in the portfolio,
- exposes the portfolio to general market risk, and
- follows a pattern because when investors can diversify at minimal or no cost, they do so.
Importance of Idiosyncratic Risk:
Risk Professionals must understand the broad categories of risk. There are two levels of risks involved: company-specific risk and systematic risk. Hence, it is essential to understand the idiosyncratic risk to understand the risk dimensions well.