June 18, 2021

Idiosyncratic Vs Systemic Risk

Idiosyncratic Vs Systemic Risk

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The idiosyncratic definition means to relate to idiosyncrasy; peculiar or individual. It is a distinctive or peculiar feature or characteristic of a place or thing.

Idiosyncratic risk is one category of financial risk and uncertainty that could lead to potential losses that are focused inside a specific individual asset, sector, industry, or asset class. It is the concentration of risk into one location. 

In the financial world, idiosyncratic versus systemic risk refers to risk related to a specific stock, commodity, currency, or asset. Idiosyncratic risk affects only one thing while systemic risk affects an entire market. Idiosyncratic risk can be managed through diversification but systemic risk can’t be avoided.

When an individual company is discovered committing fraud then that risk is priced into the stock and bonds of that one company. If the economy falls into a recession that risk is priced into the whole stock market and shows up as systemic risk in the indexes as most stocks fall in unison. 

Systemic risk an effect an entire industry first like finance was affected in 2008 during the real estate crisis and then spread across the rest of the market. Other times systemic risk can be contained in one industry like brick and mortar retail during the rise of Amazon. 

Solving business problems can be different based on the distinction between the individual business operations and the system at large, depending on if the problem is idiosyncratic or systemic.

Idiosyncratic risk lies with the company, business, or management while systemic risk lies with the economy, industry, and technological advances. 

Idiosyncratic risk is what the wealthiest people in the world took to build their fortunes. Warren Buffett, Mark Zuckerberg, and Bill Gates kept the majority of their wealth in the companies they created, built, and grew for long periods of time to accumulate such astounding net worths. The same type of idiosyncratic risk is what ruined many hedge funds like Long Term Capital management and Amaranth when a large trade with leverage was the wrong trade. 

The best way to manage idiosyncratic risk is with diversification so each trade is just one of your next one hundred trades and no one trade can ruin your whole account. Leave the single big bets on companies to the long term investors if you want to survive long term as a trader. 

“Diversification is the only free lunch in investing.” – Harry Markowitz

“The Holy Grail of investing, is to diversify a portfolio that reduces risk without impacting returns.” – Ray Dalio