Idiosyncratic Risk

Idiosyncratic risk, also known as specific or unsystematic risk, is tied to a particular industry, company, or asset class. For instance, investing in a mining company might face idiosyncratic risk if a vein being explored turns out to be worthless, affecting only that company's performance, not the broader market.

Before investing in the financial market or non-financial assets, you need to be aware of two key aspects — namely, risks and returns. Risks can come in different forms. Broadly, they may be systematic or unsystematic. While systematic risk is common to all assets within a given asset class or to the financial market as a whole, unsystematic or idiosyncratic risk is different. It is a type of risk that pertains specifically to a given asset.

In this article, we take a closer look at the meaning of idiosyncratic risk, why it occurs, how you can minimise it and more.

What is idiosyncratic risk?

Idiosyncratic risk is a type of financial risk that is associated with a specific asset or investment option. It is inherent to the investment type and is not related to broad market factors. So, it is the opposite of systematic risk, which is why it is also known as unsystematic risk.

Example of idiosyncratic risk

One common example of idiosyncratic risk is how the decisions taken by a company’s management could affect its stock price. For instance, say a company has recently relieved some of its key management personnel. This could cause a significant drop in the company’s stock price because it may cause concerns about the future growth of the entity. This type of risk is not related to the broad market. Instead, it is specific and unique to the company and its current issues.

Causes of idiosyncratic risk

This kind of risk may be triggered by different factors, depending on the type of asset or investment you’re looking at. Some common causes of idiosyncratic risk in different investments include:

• Company-specific events like management changes or mergers and acquisitions
• Industry-specific factors like regulatory changes or technological developments
• The financial health of a company
• The decisions taken by a company’s management
• Operational issues in a company, like supply chain disruptions or production delays

Types of idiosyncratic or unsystematic risk

Idiosyncratic risk can be categorised as follows:

• Operational risk: This includes risk factors associated with a company’s operational capabilities, which are all unique to the entity and not affected by broad market sentiment.
• Business risk: Business risk is a type of unsystematic risk that stems from any competition that a company faces due to a new product or entrant in the market sector or industry.
• Regulatory risk: This includes the risk that any new regulatory policies or changes to existing regulations may adversely impact a company’s operational capabilities or business strategy.
• Financial risk: This type of idiosyncratic risk stems from financial aspects of a company, such as high debt levels, consistent losses, poor cash flow management or even the risk of insolvency.

How to measure idiosyncratic risk?

You can measure the idiosyncratic risk of a company’s stock or any other asset using the following metrics and strategies:

• Variance differences: Idiosyncratic risk can be measured as the variance of a stock over and above what can be attributed to the market or systematic risk.
• Standard deviation: This tool measures how much an asset’s returns deviate from its mean returns. A higher standard deviation indicates greater idiosyncratic risk.
• Correlation analysis: You can also examine the correlation coefficient to estimate how much an asset’s returns move w.r.t other assets or indices.
• Tracking error: This metric measures how consistent an investment’s returns are when compared to another benchmark. A higher error could indicate a higher idiosyncratic risk.

How to reduce idiosyncratic risk?

To mitigate unsystematic risk as much as possible, you need to take certain measures. They include the following:

• Diversification:
  By spreading your investments across different asset classes, industries and even geographical regions, you can reduce asset-specific risk significantly.
• Hedging:
  Hedging can also help reduce unsystematic risk because it allows you to take an opposite position in the same or a related asset, thereby offsetting potential losses.
• Risk analysis:
  Additionally, to minimise this type of risk, you must first be aware of how much idiosyncratic risk you are taking. A thorough risk analysis can help you with this.

Idiosyncratic risk and mutual fund performance

This type of risk plays a significant role in understanding mutual fund performance. When you are evaluating the suitability of a mutual fund for your portfolio, you must consider this risk in addition to other factors like market risk.

A high level of idiosyncratic risk may be a sign that the fund’s returns are heavily influenced by asset-specific factors rather than broad market aspects. You can use metrics like alpha (which measures the excess returns) and tracking error (which is the deviation from the benchmark) to assess how well a scheme is handling its idiosyncratic risk.

Idiosyncratic risk vs systematic risk

Now that you know what idiosyncratic risk is and how you can reduce it, check out how it differs from market or systematic risk.

Conclusion

This sums up our guide on idiosyncratic or unsystematic risk and how you can manage it effectively. This concept is particularly relevant to mutual fund schemes as they involve a mix of different assets, each with distinct risks. The level of systematic and idiosyncratic risk will help you assess if a mutual fund scheme aligns with your risk tolerance levels.

To compare mutual funds of different types and make an informed choice, check out the 1,000+ options available on the Bajaj Finserv Mutual Fund Platform. You can identify the funds that could help you meet your financial goals without exceeding your risk tolerance. Then, you can start a SIP or make a lump sum investment in those funds easily online through this platform.