Idiosyncratic risk is a risk which affects only one stock or security. This investment risk can be addressed by diversifying a portfolio to ensure that it does not rely too heavily 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 could 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 lead to devaluation of a single security without damaging a whole portfolio. For example, a company may experience a strike action which brings stock prices down as consumers become concerned. Likewise, a company may be subject to a large suit, a decline in earnings, or a similar event which causes it to decline in value because investors grow less confident. These are all risks which can impact any security at any given time.
This type of risk is small. Idiosyncratic risk affects securities associated with a particular company only, for lengths of time which 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 skilled investors who watch the market closely. Rather than attempting to avoid this risk by selecting specific securities, people instead keep their portfolios diverse so that they can manage idiosyncratic risk and reduce its effect on them.
When researching securities for purchase, 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 would not diversify a portfolio. Likewise, if Abc Company is a subsidiary of Xyz Corporation, stocking a portfolio heavily with securities from both these companies may not be wise because the fortunes of one could have an impact on the other.
Diversification is one of the first lessons people are taught when they are exploring investments and learning about how to develop portfolios. Investors who are not comfortable with trying to select an appropriate balance of securities for a portfolio can choose to utilize the services of an investment advisor. Investment advisors are familiar with the many types of risks involved in the investment world and they can counsel their clients to make sound choices, or work as portfolio managers to handle investments directly on behalf of their clients.
