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Idiosyncratic risk affects only one stock or security and can be addressed by diversifying a portfolio. This risk can be caused by events such as strikes, lawsuits, or declines in earnings and is difficult to predict. Diversification is important to manage this risk, and investors may seek the advice of an investment adviser.
Idiosyncratic risk is a risk that affects only one stock or security. This investment risk can be addressed by diversifying a portfolio to ensure that it is not overly reliant on any given investment product. This ensures that when a security is affected by idiosyncratic risk, it does not drag the entire portfolio down with it. One might consider this particular form of risk a great illustration of the saying “don’t put all your eggs in one basket.”
A number of things can drive a single security down without damaging an entire portfolio. For example, a company may experience a strike that lowers share prices as consumers become concerned. Similarly, a company may be subject to a major lawsuit, a decline in earnings, or a similar event that causes its value to decline because investors are less confident. All of these are risks that can affect any security at any given time.
This type of risk is small. Idiosyncratic risk affects the values associated with a particular company, for periods of time that can vary, depending on the nature of the risk. Also known as unsystematic risk, it can be difficult, if not impossible, to predict, even for qualified investors closely watching the market. Instead of trying to avoid this risk by selecting specific stocks, people keep their portfolios diverse so that they can manage idiosyncratic risk and reduce its effect on them.
When researching stocks to buy, people should think about how idiosyncratic risk might affect them. Buying large amounts of stocks and bonds in Xyz Corporation, for example, might be a bad idea because it wouldn’t diversify a portfolio. Similarly, if Abc Company is a subsidiary of Xyz Corporation, holding a portfolio heavily holding securities from both companies may not be prudent because the fate of one could impact the other.
Diversification is one of the first lessons people are taught when exploring investments and learning how to build portfolios. Investors who are not comfortable trying to select an appropriate stock balance for a portfolio may choose to use the services of an investment adviser. Investment advisers are familiar with the many types of risks involved in the world of investing and can advise their clients to make sound decisions or work as portfolio managers to manage investments directly on behalf of their clients.
Smart Asset.
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