When Risk Offers No Rewards
Idiosyncratic (also referred to as nonsystematic) risk is specific to a single asset or to a small group of assets. Idiosyncratic risk has little or no correlation with market risk. Therefore, it can be substantially mitigated or eliminated by sufficiently diversifying a portfolio. Because it can be mitigated, investors aren’t rewarded with higher expected returns for taking idiosyncratic risk.
In fact, one of the major anomalies (or “puzzles”) in finance is that stocks with greater idiosyncratic volatility (IVOL) have produced lower returns. This represents an anomaly because idiosyncratic volatility is viewed as a risk factor—greater volatility should be rewarded with higher, not lower, returns.
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