Idiosyncratic Risk
Systematic risk tends to be the inevitable thing that each investor must tolerate at a certain level. It is the risk of a change in price triggered by the particular instances of a specific security, or by a risk that is industry or company-specific. Simply stated, it is a risk that impacts only a specific organization or industry but not the entire market.
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What is Idiosyncratic Risk?
Idiosyncratic risk sometimes is also referred to as unsystematic risk which is a type of investment risk that is related to a particular type of asset or group of assets or in some cases a specific asset class. Since it affects only a specific asset it is the opposite of systematic risk which affects the entire market. It refers to the risk which emerges out of controlled and known variables that are related to a specific industry or security. Idiosyncratic risk is rooted in individual companies and can be mitigated by diversifying the investment portfolio or hedging. Diversification can be created in the portfolio by investing in assets with a low correlation which means those assets generally don’t move together in the market. If the investor is losing money in one or more of the assets then he would be gaining in the non-correlated assets thus minimizing his losses.
Advantages:
- Idiosyncratic risk can be controlled with the help of portfolio diversification or hedging.
- It does not impact the entire economy but only a particular business or industry.
- The risk occurs majorly through internal factors hence it can be controlled by taking internal measures.
- The scale of impact is relatively lower compared to systematic risk.
- The number of people involved and the amount of funds is less.
Disadvantages:
- By nature, idiosyncratic risk is very unpredictable and irregular.
- Protection against idiosyncratic risk requires complete knowledge of the asset or sector.
- Although the entire economy is not affected it acts as a hazard to a particular business or sector and disrupts the business which impacts the profits.
- The risks cannot be avoided due to the geopolitical crisis and hence takes a lot of time to settle.
- A large pool of resources has to be implemented by the policymakers to resolve the situation.
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Example:
In April 2018, Lending Club Corporation was accused by the Federal Trade Commission of debiting money from their customer’s account without authorization and also using deceptive practices with borrowers with regard to the fees. The shares of Lending Club Corporation dropped by 15% in sort order. The market reacted very quickly to bad news from the company. This shows us that the risk occurred due to specific reasons regarding the company and not the entire economy and hence only affected the company.
Idiosyncratic risk is very dynamic and the nature of the problem is varied from each other. There is no correlation with the economy hence the policymaker does not pay attention to the risk as they are related to a specific industry or sector and can be mitigated by means of private participation only.
Author -Sanjana Rau
About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.
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