Idiosyncratic Risk Definition, Types, Examples

Investors can reduce their exposure to unsystematic risks by diversifying their portfolio. The notable characteristic of unsystematic risk is the fact that the risk can be mitigated through portfolio diversification, i.e. the strategic inclusion of uncorrelated assets in a portfolio. Unsystematic Risk, or “idiosyncratic risk”, refers to the risk inherent to a particular company or industry, rather than from the broader economy and financial markets.

Asset Allocation to Manage Systematic Risk

Generally, industries that are characterised by rapid innovation and stringent regulations often have significantly higher industry risk. Management risk is the uncertainty surrounding the competency and decisions of a company’s key management team. Some of the factors that contribute to management risk involve poor strategic choices, ineffective leadership and corporate governance issues. Recently, we can take the outbreak of the coronavirus pandemic as an example.

A simple example of unsystematic risk is litigation risk, meaning the danger that a company might face legal action. For example, a company whose products are more likely to be defective will face more class-action suits than other companies in the same industry. Types of systematic risks can include interest rate changes, recessions, or inflation. Systematic risk is often calculated with beta, which measures the volatility of a stock or portfolio relative to the entire market. Systematic and unsystematic risk are two entirely different types of risk, each with its own set of characteristics. This risk can be classified into two major categories — systematic risk and unsystematic risk.

1. Since unsystematic risks are unique to each company, they can be minimized through diversification.
2. Setting asset allocation ranges rather than fixed targets also provides flexibility to adjust allocations in response to signals about the market cycle.
3. The risk of loss in online trading of stocks, options, futures, forex, foreign equities, and fixed income can be substantial.
4. Armed with this knowledge, it then becomes possible to identify the most optimal strategies for protecting your downside.
5. A balanced investment portfolio typically employs a mix of asset allocations and diversification to mitigate various types of risks.

This article provided a short overview of basic types of investment risk. Also, you can discuss risk with a trusted, professional advisor who can provide relevant answers as you build your investment portfolio. After the next year rolls around, the company might find that consumers actually prefer bigger phones and watches. Much of the existing inventory for the aforementioned technology unsystematic risk example company either goes unsold or sells at a major loss. Operational risks can result from unforeseen or negligent events, such as a breakdown in the supply chain or a critical error being overlooked in the manufacturing process.

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1. In general, unsystematic risk can be managed through diversification, while systematic risk cannot be avoided.
2. But investors can manage unsystematic risks by holding a diversified portfolio across various assets, sectors and geographies.
3. It is the uncertainty that comes with operating in a particular sector, caused by factors like management decisions, financial practices, or events related to the firm.
4. This forces investors to buy low and sell high – adding equities after market declines and trimming them after rallies to capture value.
5. What is important is that an unsystematic risk is not inherent to every security or at least not a great majority of securities.
6. However, it is essential to understand that despite strong risk management measures, unsystematic risks cannot be eliminated entirely.

We’ll send you resources to support independence, health, and economic security. Earlier in 2023, BYJU’s had raised more funding at a valuation cap of $22 billion. Since the pandemic, the management team of Byju undertook an aggressive approach to achieve growth at all costs by engaging in M&A.

Advisors can rebalance by trimming overweight asset classes and directing proceeds into underweight areas. Ongoing portfolio reviews also allow advisors to assess if the current construct remains appropriate for the investor’s goals as their life situation evolves. Setting asset allocation ranges rather than fixed targets also provides flexibility to adjust allocations in response to signals about the market cycle.

Investments

The views expressed in this material are solely those of the author and/or QuantInsti and Interactive Brokers is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to buy or sell any security. It should not be construed as research or investment advice or a recommendation to buy, sell or hold any security or commodity. We will discuss the definition of unsystematic risk now to make it clear in brief what this type of risk implies.

Conclusion: Integrating Risk Considerations into a Cohesive Investment Strategy

Armed with this knowledge, it then becomes possible to identify the most optimal strategies for protecting your downside. Unsystematic risk—when it comes to investing in stocks—can be measured by the unsystematic variance. That is calculated by subtracting systematic variance from the total variance. Strategic risk stems from the uncertainty surrounding the management’s business strategy. For example, a company entering into a strategic partnership with another entity at unfavourable terms is a form of strategic risk. Business risk includes all the risks that threaten a company’s revenue, profitability and overall performance.

Hypothetical Examples of Unsystematic Risks

It’s also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk. In the context of an investment portfolio, unsystematic risk can be reduced through diversification—while systematic risk is the risk that’s inherent in the market. Unsystematic or idiosyncratic risk is the risk unique to a specific asset or company. Unlike market-wide risks, this type of risk can be reduced by diversifying investments across different securities, limiting exposure to any single asset’s performance. Unsystematic risks are uncertainties surrounding a specific industry or a company.

Examples of unsystematic risk include business risk, financial risk, default risk, and liquidity (marketability) risk. Understanding the nature of systematic risk highlights why it is considered unavoidable. Diversification across various assets and sectors isn’t enough to hedge against market-wide downturns caused by systematic risk.

Systematic risk refers to market-wide uncertainties that affect all businesses, while unsystematic risk is industry or company-specific. Stocks face higher systematic and unsystematic risks but offer growth potential. Bonds carry systematic risk due to interest rate sensitivity but provide stable income. RJO Futures provides investors with access to a world-class team of investment professionals who can provide critically important context and guidance with regard to systematic and unsystematic risk.

Advisors can then recommend appropriate asset allocations across stocks, bonds, cash, and other securities to align with an investor’s financial goals and comfort with risk. More conservative investors may favor a higher allocation to fixed-income assets, while more aggressive investors may tolerate more equities exposure. While diversification is effective for controlling unsystematic risk, it cannot safeguard a portfolio against systematic risk. However, properly distinguishing between systematic and unsystematic risks enables more targeted risk management through diversification and hedging strategies. Unsystematic risk, also known as specific risk or diversifiable risk, is the risk that is specific to a particular company or investment.

This means the negative performance of one asset could be offset by the positive performance of another. Portfolio managers recommend constructing diversified portfolios to potentially reduce exposure to unsystematic risks. But investors can manage unsystematic risks by holding a diversified portfolio across various assets, sectors and geographies. Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in investing in a specific asset, such as a stock.