Controlling Systematic and Unsystematic Risk

The recent upheaval in the world markets has made investors reconsider risk and how it effects their investments.  One misguided idea is risk is a bad thing for investors.  But that simply isn’t true; risk is the way investors make money.  They receive returns in exchange for taking risk others won’t.  But if these risks are contained, investors will lose a lot of money.  Two risks investors need to understand are unsystematic risk and systematic risk.

Unsystematic Risk

Unsystematic risk refers to a risk that doesn’t involve the whole financial system but is restricted to an individual stock or sector.  This could be anything from the chance of a company’s founder or CEO being fired to a collapse in metal prices hurting the earnings of mining companies.  Many of the risks involving individual companies come rather suddenly and are impossible to predict.  Every investor in companies must realize their stock’s price will fall if they release bad earnings.  Same applies to revelations of fraud or misstated earnings.  Bankruptcy, no matter how low the risk, is another risk that investors must keep in mind when involving companies.  Many people don’t know a large portion of a stock’s value is derived from its sector.  When investing in an individual stock, keep in mind the stock’s sector.  The risk of a sector, from the price of raw materials to wide decreased earnings, must be considered for every investment.

How to lower unsystematic risk

One of the ways to lower the unsystematic risk of a whole portfolio is to use diversification.  This means buying stocks from many different sectors so the stocks don’t trend with each other.  In general, when some sectors or industries are making money, others will be losing money.  The ups and downs of a portfolio’s value are balanced out with diversification.  However, there are many downsides to diversification.  This method can lower the total returns of a portfolio by having both losses and gains which may balance each other out.  Diversification also doesn’t protect against systematic risk, the second type of risk.

Systematic Risk

Systematic risk refers to risk that effects the whole financial system.  These black swan events can cause panic across investment markets and start off a recession.  The most recent one happened in the credit crisis of 2007-2008, when the world markets verged on collapse.  The problem with systematic risk is that it can’t be hedged away with a method like diversification among stocks.  During the most recent downturn, almost all asset classes fell together.  The world markets, from stocks to commodities, have become so tightly wound that they now move in tandem.  Investors have to use unique methods to prepare for systematic risk.

Lowering Systematic Risk

One of the best ways to lower systematic risk is to bet against the market.  This is done either by short selling stocks or buying put options.  Both are slightly more complicated than buying regular stocks, but they may be the only way to prevent some systematic risk.  Short selling makes money when a stock goes down.  However, the short seller also loses money when the stock goes up.  It’s just the opposite of regular stock investing.  The problem with short selling is investors will lose a lot of money doing it unless there is immediate systematic risk and the market moves downward. 

In theory, short sales could go up forever, losing investors an infinite amount of money (this is an exaggerated example, of course.)  Put options are like bets placed on the direction of the market.  They increase in value when the stock or market decreases, but go to zero when the stock increases.  Investors only lose their initial investment.  However, options are complicated derivatives and this article does not explain them enough to justify trading in them.  It’s best to learn more about options before buying and selling them. 

Investing is all about controlling risk.  Without controls, money will be lost.  This applies equally to all participants in the markets, from investment banks and hedge funds to the investor growing his nest egg.  Of course, it’s impossible to eliminate any risk from a portfolio.  Without risk, money won’t be made.  However, investors on top of their financial risk are those who get ahead.