As the factor risk for holding an asset class goes down, the idiosyncratic risk increases. If there is less factor risk, there is more unique or unexplained, although diversifiable, risk associated with a security.
An investor who switches to investments that have lower factor risk is not reducing total risk. There is a switching to risks that cannot be generalized or easily measured. There is a move from risk factors you know and can measure to risks that are not well-known; however, total risk is still important.
Rebalancing across asset classes will change factor risks. It will change correlations, but it will also increase idiosyncratic risks.
There is a problem with the switching from factor to idiosyncratic risk. These unique risks, to be managed effectively and not just diversified away, require more security-specific knowledge. There is more internal uncertainty with picking those securities that have more idiosyncratic risk versus core risk factors like equity, credit and rates.
We have discussed the difference between internal and external uncertainty. Internal uncertainty is associated with our knowledge, skill, or ignorance about a specific situation. Investors may not have all of the information necessary on the specific company or asset class. It cannot be linked to specific risk factors. External uncertainty is associated with the disposition of an event.
In the case of an asset class that has a high degree of credit risk, we know the risks, so we have limited internal uncertainty; however, we have the external uncertainty with not knowing the direction of the credit risks. If there is high idiosyncratic risk, there may be little external risks associated with known factors, but a significant amount of security specific risk.
Those who have research issues associated with idiosyncratic volatility find that it is important with pricing cross-sectional returns. There is a positive relationship between risk and return as measured by total risk. Know your factor risks but realize that reducing factor risks for "unexplained" risks is not a solution. It just changes risks and changes the work requirements for any investor.
(See Internal versus external uncertainty - Making distinctions for decision-makers)
We have discussed the difference between internal and external uncertainty. Internal uncertainty is associated with our knowledge, skill, or ignorance about a specific situation. Investors may not have all of the information necessary on the specific company or asset class. It cannot be linked to specific risk factors. External uncertainty is associated with the disposition of an event.
In the case of an asset class that has a high degree of credit risk, we know the risks, so we have limited internal uncertainty; however, we have the external uncertainty with not knowing the direction of the credit risks. If there is high idiosyncratic risk, there may be little external risks associated with known factors, but a significant amount of security specific risk.
Those who have research issues associated with idiosyncratic volatility find that it is important with pricing cross-sectional returns. There is a positive relationship between risk and return as measured by total risk. Know your factor risks but realize that reducing factor risks for "unexplained" risks is not a solution. It just changes risks and changes the work requirements for any investor.
(See Internal versus external uncertainty - Making distinctions for decision-makers)
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