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Systematic Risk and Investors

Posted on Friday, November 16th, 2018 by MarketBeat Staff

Anne lives in Boston. Her best friend lives across the country in Los Angeles. Since she only has so many vacation days and every second count, the most efficient option for visiting her is to fly. After all, she could be there in a matter of hours. And if she got a direct flight, she could be there even sooner. But Anne is afraid of flying and she perceives flying as being riskier than driving or perhaps even taking the train, even though those options would take more time and are not necessarily any safer.

Bill, on the other hand, loves to fly and takes a plane whenever he can, even on shorter trips where driving would be a far more cost-effective, and efficient alternative. But Bill hates long car trips and he gets anxious at the thought of having car trouble and being stranded in the middle of nowhere. Even though the likelihood of that happening is low and flying has its own risks, for Bill, the reward of flying outweighs its risk.

Mark is a healthy 50-year old male who exercises regularly, has never smoked a day in his life and would seem to have a long life expectancy. But his family has a history of heart disease and so he makes sure to schedule regular visits to the doctor’s to make sure he can head off any problems before they start.

Finally, we have Sabrina, a 40-year old lawyer who is wondering about the security of her portfolio but is also concerned about having the kind of retirement she desires. But with all the volatility in the market, she isn't sure if she wouldn't just be safer pulling out of the market altogether.

While only one of these examples has anything to do with investing, each one provides an insight into an investing concept known as systematic risk. It’s a risk that may or may not occur, is difficult if not impossible to predict, but nevertheless is a real risk, and for that reason is something every investor must consider in terms of their overall risk tolerance.

In this article, we'll define systematic risk, show how it's different from unsystematic risk and look at strategies to manage systematic risk as much as possible.

What is systematic risk?

Systematic risk is most simply defined as the inherent risk an investor takes by having money invested into a specific asset class. It is a risk that can be managed through strategies like asset allocation and diversification, but the only way that it can be eliminated entirely is to not be invested in the market.

Put another way systematic risk is the opportunity cost associated with choosing one type of investment over another. The investing mantra “stocks beat bonds; bonds beat cash” reflects the concept of systematic risk and associated reward. There is potentially a higher reward for investing in stocks, but also a higher opportunity cost.

Systematic risk in the market deals with macroeconomic, or general economic, factors. These include things like interest rates, inflation, and unemployment. Macroeconomic features look at the economy as a whole as opposed to a specific industry (such as technology stocks or utility stocks).

Like many things, the best way to understand systematic risk is to understand unsystematic risk. Unsystematic risk is related to a specific asset class or even a group of securities within an asset class. For example, there are times when a specific stock sector like industrials is declining while another, like technology, may be advancing. Likewise, different asset classes like stocks and 10-year Treasury bonds tend to move in different directions. Unsystematic risk usually lies in company-specific or sector-specific concerns. For example, when the Trump administration placed tariffs on steel and aluminum earlier in the year, there was a trickle-down effect on some manufacturers who relied on the low cost of imported steel and aluminum in their pricing. When these companies announced that they would have to increase prices to offset the higher cost of steel, their stock prices dropped. That’s an example of unsystematic risk. An informed, diversified investor will be sure to have their exposure to every sector limited and balanced with other sectors to help offset that risk.

Examples of systematic risk for investors

An example of systematic risk would be evident in the phenomenon that usually occurs at the onset of every election cycle, particularly when a change in the balance of power is expected. The market becomes uncertain, and because they are uncertain, there is a systematic risk that usually causes the market to decline until the results are known. This is an example of “the unknown always being worse than the known”. Once investors get a confirmation of the direction that public policy will take, particularly as it relates to business, they can make informed investment decisions.

Another example of systematic risk is a change in interest rates. Whenever investors anticipate that the Federal Reserve will raise rates, the market tends to decline because stocks tend to underperform in the face of higher borrowing costs. On the other hand, when interest rates are expected to remain the same or even decline, the market tends to respond favorably on the presumption that a company’s cost of debt will be lower.

One of the more profound examples of systematic risk occurred during the Great Recession. In general, recessions have an adverse effect on stocks. However, during this period, there were few safe havens for investors who found that even precious metals remained volatile during this time.

Can systematic risk be avoided?

The only way to avoid systematic risk when investing is to not invest in the market. One could argue that creates another form of risk altogether, but nevertheless, all investing comes with risk. However, systematic risk can also be looked at as being an opportunity cost. The greater the potential reward, the more willing an investor may be to assume that risk. This is why one of the first assessments a financial advisor will perform with a client is their risk tolerance.

If an investor has a low-risk tolerance, it does not necessarily mean that they need less exposure to equities, but they will probably be more comfortable with blue-chip stocks and/or defensive stocks that tend to be slow, steady performers. These investors will be content with less upside growth potential in return for less risk of large losses when the market underperforms.

Investors with a higher risk tolerance will not necessarily have a higher percentage of their portfolio in equities, but their portfolio will include growth stocks, aggressive growth stocks and perhaps even some speculative stocks.

To summarize, there is no way to avoid systematic risk aside from not being invested in the market. There are however some strategies you can use to help limit your exposure to systematic risk.

Strategies for managing systematic risk

The first strategy is to practice diversification. This doesn’t just mean investing in different asset classes, but ensuring that your portfolio is not overly weighted to one sector or another. For example, if you only own technology stocks, you may want to diversify into other unrelated sectors. That way, if economic events affect the technology industry (unsystematic risk) the rest of your portfolio may not be affected and may help cover losses you sustain. For example, in August of 2018, the renowned FAANG stocks that are normally the darlings of the tech stock realm took a beating. But that was different from the general correction that the entire market sustained in October of that same year. Investors who had a balanced portfolio would have been more protected from the first scenario and no more risk than other investors in the second.

Another good practice for managing systematic risk is asset allocation. This is similar to diversification except where diversification answers the question “what assets are you investing in?”; asset allocation addresses the question of “how much are you investing in each asset?” The answer will be different for every investor. A traditional model for a young professional with 30 years or more before retirement would be to have a portfolio that is 70% equity/25% bond/5% cash. For someone approaching retirement those numbers may be closer to 55% equity/30% bond/15% cash and for someone in retirement, it may be 30% equity/45% bond/25% cash. Even with asset allocation, risk tolerance plays a role. Many retirees are living longer which may cause some of those investors to continue to keep a relatively high amount of their portfolio in equities so that their portfolio enjoys some growth that will help ensure they don't outlive their money. Conversely, some younger investors may be willing to set more modest retirement goals for the security of not having exposure to the volatility of the market.

A third strategy for managing systematic risk is to check a stock’s beta. Beta is a measure of an equity's volatility in relation to the performance of an index – typically the S&P 500. Beta is used in the capital asset pricing model (CAPM). One way to think about the beta is how likely a stock's return will correlate with the return of the market. So a security with a beta of 1 means that it is likely to be highly correlated to the market. If the market has a return of 8%, investors can expect a similar return on that stock. If a beta has a beta above 1, it will generally have a higher return when the market is up, but also will tend to perform below the market when the market goes down. Investors with a low-risk tolerance will be attracted to stocks that have a beta of less than 1 (but not 0) as those stocks tend to show less volatility. Utility stocks tend to have a beta less than 1. While tech stocks tend to have betas above 1. This makes sense since those stocks have a possibility of a higher return but also offer more risk.

The bottom line on systematic risk

The relationship between risk and reward is at the core of every investment strategy. Systematic risk is the risk that is inherent simply by being in the market. Examples of systematic risk include macroeconomic considerations like inflation and interest rates, changes in economic policy such as higher or lower taxes, and geopolitical events such as natural disasters or wars.

Systematic risk is unpredictable and the only way to be completely protected from it is to not be invested in the market. The likelihood of a portfolio being affected by systematic risk does not increase with an aggressive portfolio or decrease with a conservative portfolio, but the consequences of that risk will be different. With that said, there are steps you can take to minimize your portfolio’s exposure to systematic risk. Diversification means that you are not only investing in different asset classes (bonds, equities, cash, etc.) but that you are also showing diversification within each asset class. So your portfolio of stocks will include not only defensive stocks such as utility stocks but also some growth stocks that have a greater chance of a higher return.

In addition to diversification, you will want to monitor your portfolio’s asset allocation. In other words, what percentage of your portfolio is invested in different asset categories? An investor’s allocation will change depending on their stage in life and on their risk tolerance. Another strategy for managing systematic risk is to pay attention to a stock’s beta value. Beta is a measure of an asset’s volatility in relation to an index. Conservative investors will be attracted by assets with a beta of less than 1 as these tend to be less volatile than the broader market. More aggressive investors will look for stocks with a beta above 1 as those stocks will give them the possibility of a higher return.

 

 

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