Specific Risk Definition, Interpretation and Quiz

1. Define - Define Specific Risk of individual assets.
2. Calculate - See how Specific Risk is decomposed from total variance.
3. Context - Use Specific Risk in a sentence.
4. Quiz - Test yourself.

by Paul Alan Davis, CFA

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How to Interpret Specific Risk

Advanced

Specific Risk is measure that quantifies volatility associated with the asset alone, and is un-correlated with the Market or a group of systematic factors.

Synonyms: idiosyncratic risk, idiosyncratic volatility, stock specific risk, diversifiable risk, residual risk, residual volatility, firm-specific risk

Specific Risk is the piece that is left over after removing the systematic risk, or the risk that is perfectly correlated with the Market, or x-variable(s), in a linear regression. It can be computed for any of the three timeframes: historical, expected or forecast.

• Total Variance = (Beta^2 * Benchmark Variance) + Standard Error

The Beta^2 above means beta is squared. Standard Error refers to the square root of the variance of the residual from the regression, which represents the firm-specific uncertainty.

For context, it is most common for portfolio managers to utilize Specific Risk in their risk management software programs when forecasting risk and running portfolio optimizations.

Make note, the ratio of Specific Risk to Total Risk helps to determine the extent to which a portfolio manager is taking active bets. The higher the ratio, the more firm-specific risk the portfolio manager has baked in to the portfolio. And for diversified portfolios across 30 stocks, with size and sector diversification the ratio will likely exceed 0.50.

In a Sentence

Pat:  I prefer a multi-factor specific risk specific risk as it is slightly more accurate.
Pam:  Yeah, it's a better beta.

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Quiz

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Questions or Comments?

Still unclear on Specific Risk? Check out the Quant 101 Series, and specifically the tutorial called Stock portfolio risk decomposition into systematic and risk.

Related Terms

Our trained humans found another term in the category risk decomposition you may find helpful.

• Systematic Risk

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