Idiosyncratic Risk vs. Market Risk
The advice "don't put all your eggs in one basket"—yet there is a risk that never disappears no matter how many baskets you spread them across. Let's distinguish the risk you can eliminate through diversification from the risk you cannot.
Risk divides into two kinds
Investment risk can be broadly divided into two kinds.
① Idiosyncratic risk (unsystematic risk): risk that applies only to a specific company or asset. Things like a CEO's sudden resignation, a factory fire, accounting fraud, or a new-product failure.
② Market risk (systematic risk): risk that affects the entire market. Things like a sharp rise in interest rates, a recession, a war, or a pandemic that shake almost all assets at once.
The decisive difference between the two is 'whether it can be eliminated through diversification.'
Idiosyncratic risk can be almost erased through diversification
Idiosyncratic risk is largely offset when you spread across many stocks. Even if something bad happens to one company, something good may happen to another, and the two offset each other.
Studies suggest that if you hold roughly 20–30 stocks across different industries, most idiosyncratic risk disappears. Beyond that point, adding more stocks noticeably reduces the risk-reduction benefit.
But there's a condition here. You have to spread across 'different industries.' Holding 30 semiconductor companies isn't true diversification, because they collapse together under the same shock.
'20–30 stocks is enough' is a rough rule of thumb. How many stocks is optimal varies by study and assumption (from claims that 15 is enough to counterarguments that far more are needed). The point is that 'beyond a certain point, the marginal diversification benefit drops sharply.'
Market risk remains — and that's the price of return
Market risk, by contrast, does not disappear no matter how many stocks you spread across. When a recession comes, even a well-diversified portfolio falls along with it—as in 2008 and 2020.
In fact, this is natural. In return for bearing market risk, we can expect, over the long run, returns above a savings deposit (a risk premium). If there were no risk at all, there'd be no excess return either.
So the investor's job is clear: reduce the 'eliminable' idiosyncratic risk as much as possible through diversification, and accept the 'non-eliminable' market risk only as much as you can bear, with a plan to endure the drawdowns. Concentrating in individual stocks means shouldering even idiosyncratic risk for which you aren't rewarded.
Preguntas frecuentes
Q. If I just buy one index fund, does idiosyncratic risk disappear?
An index fund that holds the whole market is automatically diversified across hundreds to thousands of stocks, so most idiosyncratic risk is removed. But market risk remains. That's why even an index fund falls along with a recession. You've almost eliminated 'the risk that an individual company fails,' but you still carry 'the risk that the entire market drops.'
Q. What kind of risk does beta measure?
Beta measures 'sensitivity to market risk (systematic risk).' It looks at how much an asset moves along when the market moves. Idiosyncratic risk—which can be eliminated through diversification—isn't captured by beta. That's why, in theory, investors are seen as being rewarded only for the 'non-eliminable' market risk (beta).
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