What is Idiosyncratic Risk?
Idiosyncratic Risk is uncorrelated to the risk of the broader market and can be mitigated via portfolio diversification.
Often used interchangeably with the term “unsystematic risk,” idiosyncratic risk is the risk inherent to a particular company or sub-sector of comparable companies, as opposed to the economy and broader markets.
What is the Definition of Idiosyncratic Risk?
Unsystematic risk, or “company-specific risk,” arises from factors that have a disproportionately negative impact on a specific company or sub-sector with commonalities.
Therefore, idiosyncratic risk is the risk of incurring monetary losses on an investment because of its unique attributes.
The effects of unsystematic risk are constrained to certain securities or a specific industry. Thus, unsystematic risk can be mitigated through portfolio diversification, i.e. via less exposure to fluctuations of one particular investment.
In short, idiosyncratic risk is a form of diversifiable risk, while systematic risk is non-diversifiable risk.
What Causes Idiosyncratic Risk?
Some different potential causes of idiosyncratic risk are as follows.
- Operational Risk → Discretionary Management Decisions, Corporate Actions (e.g. Dividend Issuance, Stock Buyback, Acquisition)
- Business Risk → Operating Performance, Quality of Product/Service Offerings, Reputation, Branding
- Regulatory Risk → Anti-Trust Regulations, Regulatory Shifts, Legal Risk, Class Action Lawsuit
- Industry-Risk → State of Market Competition, Market Positioning (i.e. Market Share), Threat of New Entrants, Threat of Substitutes, Rising Unit Costs, Supply Chain Disruption
- Credit Risk → Unsustainable Capital Structure (High Debt-to-Equity Ratio), Risk of Default (and Insolvency), Liquidity Risk (Current Liabilities > Current Assets)
Contrary to idiosyncratic risk, market risk has broad implications on the economy and financial markets as a whole, with common examples including interest rate risk, foreign exchange risk (FX), political risk, a global economic recession, and health crises (e.g. the COVID-19 pandemic).
In comparison, idiosyncratic risk is specific to a particular investment and can be mitigated by building a balanced, well-diversified portfolio.
Idiosyncratic Risk vs. Market Risk: What is the Difference?
The difference between idiosyncratic risk and market risk is as follows.
- Idiosyncratic Risk → Idiosyncratic risk is inherent to a specific company or sub-sector (i.e. diversifiable risk).
- Market Risk → In contrast, market risk negatively affects the entire economy or sector, rather than only a specific asset or segment of similar assets (i.e. non-diversifiable risk).
While portfolio diversification can mitigate idiosyncratic risk, systematic risk cannot be mitigated, as the entire market is placed in an unfavorable, vulnerable position.
Via portfolio diversification, an investor can effectively reduce their exposure to idiosyncratic risk and protect the value of their portfolio from steep declines (and volatility).
When constructing a portfolio, the more concentrated your holdings are in a given position, the more the investment’s fluctuations in value will cause volatility in the entire portfolio’s value.
But if the portfolio is well-diversified, the portfolio is less sensitive to the fluctuations of any individual investment.
Systematic risk, as mentioned earlier, is the macro risk that affects the entire market. Hence, systematic risk is often referred to as “market risk” because the risk is unpredictable and non-diversifiable.
Total Stock Market Risk = Unsystematic Risk + Systematic Risk (Source: Passive Investing Australia)
What is an Example of Idiosyncratic Risk?
One recent example of idiosyncratic risk is the unexpected overheating problems of the newly released iPhone 15 by Apple (NASDAQ: AAPL).
The unexpected issue presented a material risk to product sales of the new iPhone 15, which had historically been a cash cow for Apple.
In response, Apple swiftly announced its software engineers were working on a software fix and had identified the bug in iOS17 causing the product to overheat, while emphasizing that there was no safety risk or negative implications on the long-term performance of the impacted devices.
Furthermore, Apple shifted a proportion of blame toward other consumer mobile applications – most notably Instagram (Meta) and Uber – for causing the iPhone 15 to excessively heat up.
While Apple has expressed optimism that the overheating issue can be easily resolved with the upcoming software updates, the matter could still dampen product sales at a critical point when the company has suffered three consecutive quarters of year-over-year (YoY) declines in sales.
Once the news broke that the iPhone 15 had overheating issues – which coincided with unconfirmed rumors that China was considering banning Apple devices at the workplace – the stock price of Apple declined sharply, reflecting the concept of idiosyncratic risk.
(Source: Associated Press)