Idiosyncratic vs. Systematic Risk
Why Savvy Investors Should Understand the Difference
This week, we’re breaking down two risks every investor should understand: idiosyncratic vs. systematic. One can help drive long-term returns; the other often just adds noise. In our book, Close the Gap and Get Your Share, we dig deep into this distinction—now we’re bringing that insight to the blog:
IDIOSYNCRATIC VS. SYSTEMATIC RISK
Idiosyncratic risks are those specific to individual assets, regions, and companies. For example, the risk of a CEO making a bad decision that imperils the company, the accountant that “cooks the books,” or the insurance policy that didn’t cover the damage.
Let’s imagine you see a company you believe will do well in the future and consider pouring all your money into its stock. The more you put in, the more you’re going to gain, right? But it’s risky to invest all your money in one company. The company is at risk of going bankrupt, growing too fast and then stagnating, or failing to deliver the products they’ve promised. Just look at the case of Bernie Madoff, a former billionaire who ran one of the largest frauds the world has ever seen. He sold financial investments to smart, wealthy people, promising huge returns. Most of his victims will likely never be fully repaid. To reduce your exposure to these kinds of idiosyncratic risks, you should invest in multiple companies. When you diversify, you lessen the potential blow of any single negative outcome.
Since idiosyncratic risks are a type of risk, you might think you’ll earn high returns by taking them on, because “risk and return are linked.” But remember that not all risks are created equal, and that not all risks have positive expected returns. Idiosyncratic risks are one such risk: on average, you should not expect to be compensated for taking them. The reason is that you can eliminate most, if not all, idiosyncratic risks by owning a properly diversified portfolio. And if you can eliminate a risk through diversification, you should not expect to be compensated for taking the risk. Let’s see why.
You can eliminate the risk of ABC Co. having a bad CEO by investing in other companies within ABC Co.’s sector. So, if ABC Co. shutters, other companies in its industry sector will absorb its market share. And if the market cap of the sector goes up, your investment in the sector will too. You didn’t need to concentrate all your money in ABC Co. to obtain the sector’s return. You took on risk that you could’ve diversified; therefore, that risk should not be expected to be rewarded. Now, ABC Co. could have instead had a great CEO, and outperformed its competitors in the sector and made you a nice return. However, this excess return was due to luck and not for a risk that was being compensated for pre-investment. The risk that the CEO would be bad always existed; it just never materialized. While you made a good return, you should not have expected to outperform the sector’s return before the investment was made.
On the other hand, systematic risks are ones that affect the entire market and that cannot be eliminated through diversification. Examples include recessions, pandemics, and wars. These are risks you should expect to be compensated for because you can’t diversify them away, since they tend to affect entire economies and asset classes. Over the long run, unless you are very lucky, most of your returns will come from taking on systematic risks instead of idiosyncratic risks. While you will certainly realize returns based on idiosyncratic risks, they will likely wash out over time. What you’ll be left with, therefore, are returns from the systematic risks that you take.
It’s important to understand the difference between expected return and realized return. Expected return is what you should expect to receive from your investment based on the risks you are taking. You should expect to be compensated for taking systematic risks. You should not expect to be compensated for taking idiosyncratic risks. Realized return is what you actually receive from your investment, including speculative or luck-based returns. You can unexpectedly realize an outsized return because of luck, but banking on continuous luck over the many decades you will be an investor is usually not a winning strategy. If you play that game, you should expect to underperform the market.
Your goal should be to have the highest probability of achieving a given expected return based on your risk tolerance and financial goals. Because most people have too much idiosyncratic risk in their businesses, private investments, and day-to-day lives, and since you are not compensated for taking more idiosyncratic risk, you should only focus on how much systematic risk you are willing to take.
Idiosyncratic risk goes down as diversification goes up; therefore, a maximally diversified portfolio of all publicly available asset classes, from all regions, countries, sectors, and industries, will virtually eliminate idiosyncratic risk. This can all be accomplished by owning a market portfolio of all asset classes, also called a Global Market Portfolio, which we covered in chapter eleven.
YOU ONLY GET COMPENSATED
FOR SYSTEMATIC RISKS
Any company you invest in will have many idiosyncratic risks. The CEO may be bad at his job, the board might make a misguided decision, or the product quality might decline because the company is trying to cut corners.
As an investor, you can diversify to mitigate those risks. You can invest in other companies that specialize in the same area, say crude oil. Or, if you’re worried that something’s going to happen to crude oil, but you still like the energy sector, you could diversify to other non–crude oil energy companies. If you’re worried that something’s going to happen to the oldline energy sector, you could diversify to new green tech companies. Or, if you’re worried that the United States won’t perform well in the energy sector, you could invest in global energy companies.
Not all risks are created equal, so when you take risks, it’s worth knowing which risks can help you achieve the returns you want and which to avoid. And, as we discussed in chapter twelve, if you want more risk than the Global Market Portfolio, you have a few options, all of which focus on increasing the systematic risks in the portfolio.
At Quantor Capital, we help investors harness the one kind of risk that’s been shown to pay off: systematic risk. Instead of chasing elusive outperformance through stock picking or market timing, our investment strategies intentionally minimize idiosyncratic risk and focus on what the data says actually works over the long term. Want to see how this disciplined approach could work for you? Let’s talk.
DISCLOSURES: Quantor Capital, LLC. (“Quantor”) is a Registered Investment Adviser ("RIA") with the United States Securities and Exchange Commission (“SEC”). Registration does not imply a certain level of skill or training, and the content of this communication has not been approved or verified by the SEC or by any state securities authority. The information presented is being provided strictly as a courtesy and for informational purposes only. It is not intended as an offer or solicitation to buy or sell any product or security. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here. Certain sections of this communication may have been written with the assistance of AI. All sources cited are believed to be reliable, but accuracy and completeness cannot be guaranteed.
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's portfolio. Past performance does not guarantee future investment success. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the performance of your portfolio. There can be no assurances that a portfolio will match or outperform any particular benchmark. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.