Management of investment portfolio idiosyncratic risk

Abstract

The investment portfolio is a collection of securities composed according to investor’s attitude in terms of yield and risk. It includes total (total) risk that can be decomposed into systematic and idiosyncratic (non-systemic) component. The systematic part of risk is associated with the overall financial market fluctuations, while non-systemic component is associated with the particular investment. Depending on the characteristics of the securities (quality of the issuer), idiosyncratic component is varying in total risk. This paper deals with management of idiosyncratic risk. It is controllable variable that can be reduced by increasing the number of securities in the portfolio – by diversification. The lower correlation between the yields of securities in the portfolio, diversification is more effective. The first part of the paper deals with theoretical concept of idiosyncratic risk reduction through a process of diversification. The second part is devoted to empirical analysis of the impact of increasing the number of securities in the portfolio to reduce idiosyncratic risk. As an example of the financial market we use shares of companies that compose Belex 15. Also, we employ index model (one-factor model) to decompose total risk on systemic and idiosyncratic risk. The conclusion is reserved for research results.