What is Idiosyncratic Risk?
Idiosyncratic risk is a category of investment risk, uncertainties, and potential problems that are unique to an individual asset (such as the stock of a particular company), or asset group (such as stocks of a particular sector), or, in some cases, a very specific asset class (such as collateralized mortgage bonds). It's also called a particular risk or an unsystematic risk.
The opposite of idiosyncratic risk, as indicated by the latter synonym, is a systemic risk, which is the aggregate risk affecting all assets, such as stock market volatility, interest rates, or the entire financial system.
The Basics of Idiosyncratic Risk
Research suggests that idiosyncratic risk, rather than market risk, accounts for most of the variance in the uncertainty surrounding an individual stock over time. Idiosyncratic risk can be described as the microeconomic factors affecting an asset like the stock and its underlying business. It has little or no risk association representing greater macroeconomic factors, such as market risk.
Microeconomic influences are those that affect a small or restricted portion of the economy as a whole and macro forces are those that affect broader segments of the economy as a whole.
The decisions taken by the company management on financial policy, investment strategy, and operations are all idiosyncratic risks unique to a specific company and stock. Certain examples may include the geographic location and corporate culture of the operations.
In terms of industry or market, the depletion or inaccessibility of a vein or a seam of metal would be an example of idiosyncratic risk for mining companies. Similarly, the threat of a strike by a pilot or a mechanic would be an idiosyncratic challenge to airline companies.
Identifying Idiosyncratic Risk
Although the idiosyncratic risk is unusual and unpredictable by nature, researching a business or industry may help an investor recognize and anticipate, in a general way, its idiosyncratic hazards.
