Idiosyncratic risk refers to risks that are unique to an individual asset, such as the stock of a company, or to a group of assets, such as the stock of a particular industry. It is important that investors are aware of idiosyncratic risks because they can have a major impact on your portfolio and can be reduced or eliminated through portfolio diversification.
Here’s what else investors need to know about idiosyncratic risk and how to reduce it.
What is idiosyncratic risk?
Idiosyncratic risks are risks that are unique to an individual asset or group of assets, such as individual stocks or shares of companies in a single industry. Idiosyncratic risk is also called “unsystematic risk” because it affects a subset of stocks rather than most or all stocks.
Investors are broadly confronted with two types of risks: systematic risk and unsystematic risk.
- Systematic risk, also called market risk, are usually macro factors that affect entire asset classes or the market as a whole. Inflation, interest rates, recessions and wars are examples of systematic risk. Systematic risk cannot be completely eliminated through diversification as the risk applies to the entire market.
- Idiosyncratic riskinstead, refers to the risks faced by individual companies or sectors. These risks may include competitive threats, financing risks, management or operational risks – issues specific to the company or industry. Idiosyncratic risks can be reduced or eliminated through diversification.
Examples of idiosyncratic risk
Idiosyncratic risks can be classified into a number of different categories:
- Business risk: Risk that a company will face a competitive threat, for example due to a new product or a newcomer in the sector.
- Operational risk: This risk can arise from the temporary shutdown of a factory or the strike of a group of employees.
- Financial risk: Risk due to a company’s financial structure, such as having a large amount of debt on the balance sheet.
- Regulatory risk: Risk that new regulations could affect the way the company operates or its ability to make a profit.
For example, Tesla may face idiosyncratic risks due to CEO Elon Musk’s unpredictable behavior. Musk’s behavior doesn’t affect the entire stock market or even the stocks of other automakers, so the risk is unique to Tesla.
On the other hand, a strike by auto workers, as we saw in 2023, could impact the operations of several automakers such as Ford, General Motors and Stellantis. This idiosyncratic risk was unique to the automotive industry and was not felt in other economic sectors.
Companies operating in the cryptocurrency industry face regulatory risks as governments around the world struggle to regulate digital assets. But new laws surrounding crypto will not affect companies active in other sectors.
How to limit idiosyncratic risk
The good news about idiosyncratic risk is that it can be mitigated through portfolio diversification. By holding a broad stock portfolio of companies and sectors, you reduce the impact a single position has on your overall portfolio.
One of the best ways to achieve a diversified stock portfolio is to hold a low-cost index fund that tracks a broad market index, such as the S&P 500. These funds are typically available at a cost of 0.10 percent per year or less, meaning you would pay less than $10 annually for every $10,000 invested in the fund.
To be fair, if you choose to invest in a broad index fund, you will still face systematic risks, which can only be somewhat mitigated by investing in different asset classes, such as stocks, bonds and real estate.
Pitfalls when trying to diversify
While there are many types of index funds available, be sure to choose one that is diversified across sectors. Some widely followed market indexes, such as the Nasdaq, are not as widely diversified as you might think. You may face more idiosyncratic risks than you would like if your investments are concentrated in a particular sector, such as technology.
Furthermore, simply purchasing another index fund may not solve the problem, because the fund’s investments may overlap significantly with those of a first fund. For example, one of the biggest risks with index funds is that they hold a lot of comparable large-cap stocks, like The Magnificent 7. If you buy an S&P 500 fund to diversify your Nasdaq fund, you end up getting a second helping. of these big stocks, increasing your exposure to the names you want to reduce your exposure to.
