Idiosyncratic Risk: Definition, Types, Examples, and Ways to Minimize

What Is Idiosyncratic Risk?

Idiosyncratic risk is the risk that is native to an asset (like a particular company's stock), a group of assets (like a particular sector), or, in some cases, a specific asset class (like collateralized mortgage obligations). Idiosyncratic risk is also referred to as a specific risk or unsystematic risk.

The opposite of idiosyncratic risk is systematic risk, the overall risk that affects all assets, such as fluctuations in the stock market, interest rates, or the entire financial system.

Understanding Idiosyncratic Risk

Idiosyncratic risks are the factors that affect an asset at the microeconomic level. Microeconomic factors affect a limited or small portion of the entire economy, while macroeconomic forces impact larger segments of the economy.

Risks associated with company management, investment strategy, and operations are all idiosyncratic risks. Other examples can include the geographical location of operations and corporate culture. In terms of industry or sector, an example of idiosyncratic risk for coffee shops would be a weather event that causes a shortage of coffee.

Likewise, the possibility of a pilots' or a mechanics' strike would be an idiosyncratic risk for airline companies.

Idiosyncratic Risk vs. Systematic Risk

Every company has unique idiosyncratic risks. This is because every company has its own specific strengths and weaknesses, competitive landscape, and management style.

Systematic risk is market-wide risks that stem from macroeconomic considerations. This market-wide risk cannot be eliminated by adding stocks of various sectors to one's holdings. These broader types of risk encompass factors that impact not only a single asset but also other assets and the economy as a whole.

Strategies for Minimizing Idiosyncratic Risk

While idiosyncratic risk is inherently unpredictable, studying a company or industry can help an investor identify its specific weaknesses. Idiosyncratic risk is also highly unique. It can be substantially mitigated or eliminated from a portfolio by using adequate diversification or hedging.

Diversification works because one company's specific risk is unlikely to be the same as that of other companies. So, if a car manufacturer issues a product recall, it probably won't influence the price of an apparel company or a restaurant stock. The best way to diversify is to hold stocks that are largely uncorrelated with one another.

Another diversification strategy is to invest in an index fund, such as the S&P 500, through an instrument like a mutual fund or exchange-traded fund. This is a low-cost way to ensure a well-diversified portfolio.

Hedging is a strategy that takes an offsetting position in a similar security. This can be done using options contracts. If you own stock in the automaker, you can buy a protective put that will establish a price floor until the contract expires. Hedging requires an outlay of cash to purchase the options, but you can also think of it like buying insurance on your holdings.

Examples of Idiosyncratic Risk

Energy Stocks: Industry-Specific Risk

In the energy sector, the stocks of companies that own or operate oil pipelines face an idiosyncratic risk that's particular to their industry: Pipelines may become damaged, leak oil, and bring about repair expenses, lawsuits, and fines from government agencies. A pipeline accident can cause an oil company to decrease distributions to investors and cause share prices to fall.

Apple: The Role of a Charismatic Leader

Another example of idiosyncratic risk is a company's dependence on the CEO. For much of its history, Apple Inc. (AAPL) was synonymous with its co-founder, Steve Jobs. When Jobs fell ill and took a leave of absence from the company in 2010, Apple's stock continued to appreciate in absolute terms, but its valuation relative to price multiples fell.

After Jobs took another leave in early 2011, resigning as CEO in August and passing away in October, Apple's stock traded lower—briefly. Jobs was known for being a visionary and turning around Apple. As such, his leadership was part of Apple's success and its stock price. Ultimately, faith in the company and its products prevailed, and Apple stock recovered to reach new highs through early 2020.

Coinbase: Tied to a Unique Asset Class

Coinbase (COIN) is the largest North American cryptocurrency exchange and has made a reputation as being legitimate and trustworthy. Still, its stock price is largely tied to that of the crypto market. This is an idiosyncratic risk. For example, in the spring of 2022, when the crypto market experienced a severe correction, the price of COIN stock also suffered.

Explain Like I'm Five

Investors attempt to categorize the various types of risk to understand all the ways an asset can lose value. Some types of risk affect every asset in the market. If interest rates rise or a financial crisis occurs, most companies will be affected in some way. This is called systematic risk.

Some types of risk are confined to a specific asset or company, and this is called unsystematic risk. If a company is sued or loses a shipment of products, it is unlikely to have a direct impact on other companies. You can reduce your exposure to unsystematic risk by purchasing different companies, so that a crisis in one company will not affect your other holdings.

The Bottom Line

Idiosyncratic risk or unsystematic risk is the risk associated with a specific asset, such as a stock, a bond, or other assets. Every company contains its own idiosyncratic risks, which are often unrelated to what is happening in the broader market. Diversification is often a useful strategy to help counter idiosyncratic risk.