In our last post we discussed the analysis a CFO might undertake when considering whether to raise capital for a litigation. We touched upon the fact that many companies do not have a portfolio of litigation – a fact which makes it difficult to mitigate the risk of investing in a legal claim. Today, we will focus on that insight and dive more deeply into idiosyncratic risk and the value of diversification.

Generally speaking, an investor must be compensated for the time value of money and risk. The risk that an investor must be compensated for is the risk that the return on an asset will be lower than the expected return. While any investment in a litigation has substantial risk, the vast majority of that risk is what would be termed in modern portfolio theory as “idiosyncratic risk.” Idiosyncratic risk is asset-specific risk that has little or no correlation with the market. This risk can therefore be substantially mitigated or eliminated through adequate diversification. By contrast, “systematic risk” (in modern portfolio theory parlance) is risk that is inherent to the entire market or an entire market segment, and cannot be mitigated through diversification. To illustrate the difference between these two types of risk, idiosyncratic risk manifests if a company suffers a major factory closure due to a natural disaster (in which case the price of its stock will likely decline while the rest of the market remains unaffected) while systematic risk manifests if the global economy slows down (in which case the price of a company’s stock will likely decline, but so will the price of the larger market).