Lesson 2 of 25 · 6 min

Idiosyncratic risk and market risk, separated

A single price move has two causes, and only one of them can be removed by owning something else.

Any move in a single holding can be split into two parts, and the split is the reason concentration is treated as its own subject rather than as a variety of ordinary volatility.

The first part is the move the holding made because everything moved. The second part is the move it made because of itself: a product failure, a legal finding, an accounting restatement, a takeover approach. The first part is shared with every other equity you could own. The second part is shared with nothing.

r = beta × m + e

r: The return on your holding over the period, as observed.
beta: How much the holding typically moves for each 1 percent move in the broad market.
m: The broad market's return over the same period.
e: What is left over: the residual, caused by the company rather than the market.

Put numbers through it. A single large-company holding falls 14.2 percent in a month during which the broad market fell 6.0 percent, and its beta is 1.3. The market-attributed part is 1.3 × 6.0 = 7.8 percent. The residual is 14.2 − 7.8 = 6.4 percent, and that 6.4 percent belongs to the company alone. Track 1 lesson 11 introduced beta as a multiplier; this is the leftover the multiplier does not describe.

The split matters for lending because the two parts behave differently in a liquidation window. Market moves are wide but usually gradual and observable in advance across many instruments. Residual moves arrive at one instant, in one name, sometimes while trading is halted, and a lender holding one name has no other holding whose behaviour offsets them.

Key terms

Market risk: The part of a holding's movement that comes from the market moving. Every equity holder carries some of it.
Idiosyncratic risk: The part of a holding's movement caused by that specific company. It is unique to the name and unrelated to what else you own.
Residual: What is left of a return after the market-attributed part is subtracted. It is idiosyncratic risk expressed as a number for one period.

Worked example

Splitting one month's decline into its two causes

A single large-company holding with a beta of 1.3 falls 14.2% in a month. The broad market falls 6.0% over the same month. Illustrative figures.

Observed decline in the holding: 14.2%
Market decline: 6.0%
Market-attributed part: 7.8%
Residual part: 6.4%
Share of the decline that owning other equities would have shared: 55%

Slightly more than half the decline was the market. The rest was the company, and no amount of other equity exposure would have produced it.

Check yourself

A holding with a beta of 1.45 falls 21.5% in a quarter in which the broad market falls 11.0%. How much of the decline is residual?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.