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 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.
The 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.
Additionally, understanding this topic is important for investors in making decisions related to portfolio construction and risk management. By diversifying their holdings, investors can reduce the impact of company-specific events on their portfolios, but this comes at the cost of exposure to broader market risks. Therefore, investors need to strike a balance between company-specific and systematic risk, and understanding this is critical to achieving this balance. Furthermore, idiosyncratic risk can also affect companies and their management, as they may face reputational damage and other consequences if the risk is not managed effectively. Therefore, identifying and managing idiosyncratic risk is crucial for the long-term success of a company of learn signal.