Idiosyncratic Risk

What Is Idiosyncratic Risk?

Idiosyncratic risk is the part of an investment's total risk that comes from factors specific to one company, such as a product recall, a lawsuit, a change in management, or a failed research project. It is also called unsystematic risk or specific risk. Because it relates to one business rather than to the whole stock market, it does not necessarily move in step with other investments.

How It Works

The price movements of an investment can be thought of as having two sources. Systematic risk comes from forces that affect nearly all assets, such as interest rate changes, recessions, or inflation. Idiosyncratic risk is what remains after those broad influences are removed. When a company's new product launch disappoints, its shares may fall sharply while the broader market is unchanged.

Because company-specific events affect different businesses in different ways, they tend to offset one another across a large group of holdings. A single bad outcome has a smaller effect on a portfolio that holds many companies. This is the basic reasoning behind diversification.

Why It Matters to Investors

Holding only a few stocks leaves an investor highly exposed to company-specific events. Holding a broad mix reduces that exposure, though it does not eliminate the risk of a sector-wide or market-wide downturn. Under modern portfolio theory, investors are generally not rewarded with extra expected return for bearing idiosyncratic risk, since it can be removed at relatively low cost through diversification. Its size is often estimated using statistical measures of price variability, such as standard deviation.

Example

Suppose an investor owns shares in one pharmaceutical company whose main drug fails a clinical trial. The share price may drop significantly on that news alone. An investor holding a diversified fund with many companies from different industries would feel only a small effect from the same event.