What is Idiosyncratic Risk?
Also called unsystematic risk, idiosyncratic risk is price risk associated with a company's particular circumstances.
How Does Idiosyncratic Risk Work?
For example, price changes can occur in Company XYZ stock for several reasons. Some of these reasons have little to do with the company's actual operations or managerial expertise; for instance, the company is affected by but has little control over inflation, interest rates, changes in tax policy or trade relations. These things may affect the stock price, but then again those factors affect all company stock prices. That is, they are systematic.
Investors in Company XYZ stock bear those systematic risks simply by investing in stocks in general. But they also take on idiosyncratic risk with Company XYZ. Those risks might be things such as the company's ability to price its products profitably, the company's management expertise, the company's supply chain strength and the company's marketing prowess. Those things are within Company XYZ's control and thus they are risks specific to Company XYZ.
Why Does Idiosyncratic Risk Matter?
Investors often don’t appreciate that some of the factors that affect their investments have little to do with their actual investment choices -- these systematic risks are borne by all investors. Accordingly, systematic risks are what influence asset allocation; idiosyncratic risk influences stock picking.
What is most important about this notion, however, is that diversification can mitigate idiosyncratic risk. That is, an investor can buy stocks that don't 'move together' so that some will rise when others fall. Diversification generally cannot mitigate systematic risk.
