Evaluating idiosyncratic risk is helpful in determining the degree to which the performance of a given portfolio of stock might deviate from a performance benchmark. A benchmark can be the Standard & Poor's 500, any other common measure of market performance or a specific portfolio of stock that is different from the portfolio to be analyzed. Deviation may be either outperformance or underperformance. Idiosyncratic risk is the likelihood that a small number of positions in the portfolio will underperform due to unforeseen problems such as a labor union strike, natural disaster or financial mishap.
1. Evaluate the size of the companies in the benchmark portfolio and the portfolio to be analyzed. The larger the company, the less likely it will be adversely affected by a negative event. Smaller companies are more dependent on stable operations to support their per share revenues, and they have fewer facilities to take up any downtime experienced by one part of the company.
2. Assign values to the companies in each portfolio according to the companies' relative sizes. The scale may be 1 for the smallest company and 10 for the largest.
3. Evaluate the stability of each company in each portfolio with regard to fluctuations in the economy. The greater the fluctuation in performance the lower the assigned value, with 1 being the greatest earnings fluctuation and 10 being the most stable earnings performance.
4. Evaluate the diversification in each portfolio. Strong diversification would be an even distribution of stocks from many different industries and geographic service areas. The more diversified the portfolio, the higher its assigned value. Give a portfolio that focuses on one industry a 1 value and an extremely diversified portfolio a 10 value.
5. Add the values for company size, performance stability and diversification for each portfolio. Then divide by the total number of values computed to obtain the average value for each portfolio. The lower the number, the higher the idiosyncratic risk. The higher the average value the lower the risk. Compare the results for the benchmark portfolio against those for the analyzed portfolio.
- Additional filters can be added to further define the measurement of idiosyncratic risk against a benchmark portfolio. Many investment managers select for high degrees of idiosyncratic risk because it can produce the greatest returns, as well as the greatest losses. In an actively managed portfolio, it may be possible to control idiosyncratic risk through active trading, replacing any stock that appears to be vulnerable to a negative event.