Idiosyncratic Risk

Idiosyncratic risk refers to specific risks that affect individual assets or groups, like single stocks or those in a particular industry. It's called "unsystematic risk" because it only impacts certain stocks, not the entire market.
Idiosyncratic risk
3 min
12-June-2024

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

Also read - What is a Risk Profile?

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.

Also read - What is credit 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.

Related read - What is risk return trade off?

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.

Particulars

Idiosyncratic risk

Systematic risk

Nature

Specific to individual assets or investments

Applicable to the entire market or a broad market segment

Causes

Company-specific events or industry-related factors

Economic factors like interest rates, GDP etc.

Impact

Affects a single asset or a small group of assets

Affects a wider range of assets

Diversification

Can be minimised through diversification

Diversification does not have much of an impact on this risk

Measurement

Understood using metrics like alpha or the tracking error

Measured using metrics like beta or market volatility

Mitigation

Diversification and hedging can help mitigate this risk

Asset allocation techniques and risk management strategies can help reduce this risk

Examples of risk factors

Company management changes or lawsuits

Interest rate fluctuations or economic recessions

 

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.

Calculate your expected investment returns with the help of our investment calculators

Investment Calculator
SIP Calculator Lumpsum Calculator Step Up SIP Calculator
Brokerage Calculator FD calculator Mutual Fund Calculator

Frequently asked questions

What is the meaning of idiosyncratic risk?

The definition of idiosyncratic risk is the same as unsystematic risk. It is the risk that is specific or unique to each investment or security.

What is an example of idiosyncratic risk?

Some examples of the idiosyncratic risks associated with a stock include the company’s financial position, its management decisions and internal operational policies.

How is idiosyncratic risk different from systematic risk?

Unlike systematic risk, which is common to all investments within an asset class, idiosyncratic or unsystematic risk is unique to each specific investment.

Can idiosyncratic risk be minimised?

While this type of risk cannot be eliminated, you can reduce it by performing due diligence and diversifying your portfolio.

Is idiosyncratic risk represented using alpha?

While this risk is not exactly represented using alpha, both these concepts are related as they refer to the performance or risks of a specific investment rather than the broad market.

Is it possible to reduce idiosyncratic risk through diversification?

Yes, diversification is an effective way to attempt to reduce the idiosyncratic risk in any one asset or investment.

Show More Show Less

Bajaj Finserv App for All Your Financial Needs and Goals

Trusted by 50 million+ customers in India, Bajaj Finserv App is a one-stop solution for all your financial needs and goals.

You can use the Bajaj Finserv App to:

  • Apply for loans online, such as Instant Personal Loan, Home Loan, Business Loan, Gold Loan, and more.
  • Explore and apply for co-branded credit cards online.
  • Invest in fixed deposits and mutual funds on the app.
  • Choose from multiple insurance for your health, motor and even pocket insurance, from various insurance providers.
  • Pay and manage your bills and recharges using the BBPS platform. Use Bajaj Pay and Bajaj Wallet for quick and simple money transfers and transactions.
  • Apply for Insta EMI Card and get a pre-approved limit on the app. Explore over 1 million products on the app that can be purchased from a partner store on No Cost EMIs.
  • Shop from over 100+ brand partners that offer a diverse range of products and services.
  • Use specialised tools like EMI calculators, SIP Calculators
  • Check your credit score, download loan statements and even get quick customer support—all on the app.

Download the Bajaj Finserv App today and experience the convenience of managing your finances on one app.

Do more with the Bajaj Finserv App!

UPI, Wallet, Loans, Investments, Cards, Shopping and more

Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.