Educational : Diversification, systematic vs unsystematic risk
When it comes to investing and trading, risk is a constant factor that requires careful consideration. Let's explore the concepts of systematic and non-systematic risk:
Deeper Dive
Market risk and non-diversifiable risk are other names for systematic risk. It is the kind of risk that is intrinsic to the entire market or a particular area within it and cannot be completely avoided by diversification. This means that you cannot totally protect yourself from systematic risk, regardless of how diversified your investment portfolio is. There are many ways of mitigating risk in the market but due to the nature of the market there is no way to completely eliminate this risk element. There will also be a certain level of risk that you need to account for.
Unpredictability:
The unpredictability of systemic risk is one of its difficult elements. These risk factors frequently come as a surprise and can appear quickly, making it challenging to plan for their effects. Even seasoned investors can be caught off guard by events like global economic crises or political turmoil because of the intricate network of interconnected factors that affect financial markets. There is also the fact that markets are inherently fractal. You can read more about this in my publication on how the market is fractal. (Will be in related ideas)
Unsystematic Risk on the other hand refers to the risk that is specific to a particular company, industry, or asset and can be mitigated through diversification. Unlike systematic risk, which affects the entire market, unsystematic risk is unique to individual entities and can be reduced or eliminated by spreading investments across different assets. Some of these risk might be in individual companies or assets but do not have a widespread impact on the entire market. Examples include management changes, product recalls, lawsuits, technological innovations, and changes in consumer preferences. These factors can significantly influence the performance of a single company's stock or asset. There is also sector or industry specific risk. If you work for a company that produces technical indicators, changes in regulations affecting the financial industry or a downturn in the technology sector could impact the company's performance. Investing solely in one sector exposes your portfolio to a higher degree of unsystematic risk.
Unsystematic risk can be mitigated using many strategies. Two popular methods listed below.
Asset Allocation or portfolio diversification: Allocating your investments across different asset classes (stocks, bonds, real estate, etc.) can help mitigate the impact of unsystematic risk. Different asset classes may respond differently to market events. Where one asset starts to go down another might start to go up and the fall and rise of these assets might be at different severity allowing you the flexibility to deploy risk management strategies to maximise on the rising asset
Hedging: Using financial derivatives like options and futures contracts can provide a way to hedge against specific systematic risks, such as currency fluctuations or interest rate changes.
Diversification in one of the big factors in reducing your risk. As the diagram shows the more diversify the portfolio becomes the less subject it is to unsystematic risk but you will eventually get to a equalising point where you still have to account for systematic risk.
It is important to note that diversifying your portfolio is not just simply investing in as many assets or industries as possible. This process needs to be a calculated application. If not, what can happen is that you fill your porfolio with random assets and stocks that end up having bad correlation between each other causing you to lose. When you buy on one asset you will lose on another constantly making it hard for you to find and edge/alpha
Deeper Dive
Market risk and non-diversifiable risk are other names for systematic risk. It is the kind of risk that is intrinsic to the entire market or a particular area within it and cannot be completely avoided by diversification. This means that you cannot totally protect yourself from systematic risk, regardless of how diversified your investment portfolio is. There are many ways of mitigating risk in the market but due to the nature of the market there is no way to completely eliminate this risk element. There will also be a certain level of risk that you need to account for.
Unpredictability:
The unpredictability of systemic risk is one of its difficult elements. These risk factors frequently come as a surprise and can appear quickly, making it challenging to plan for their effects. Even seasoned investors can be caught off guard by events like global economic crises or political turmoil because of the intricate network of interconnected factors that affect financial markets. There is also the fact that markets are inherently fractal. You can read more about this in my publication on how the market is fractal. (Will be in related ideas)
Unsystematic Risk on the other hand refers to the risk that is specific to a particular company, industry, or asset and can be mitigated through diversification. Unlike systematic risk, which affects the entire market, unsystematic risk is unique to individual entities and can be reduced or eliminated by spreading investments across different assets. Some of these risk might be in individual companies or assets but do not have a widespread impact on the entire market. Examples include management changes, product recalls, lawsuits, technological innovations, and changes in consumer preferences. These factors can significantly influence the performance of a single company's stock or asset. There is also sector or industry specific risk. If you work for a company that produces technical indicators, changes in regulations affecting the financial industry or a downturn in the technology sector could impact the company's performance. Investing solely in one sector exposes your portfolio to a higher degree of unsystematic risk.
Unsystematic risk can be mitigated using many strategies. Two popular methods listed below.
Asset Allocation or portfolio diversification: Allocating your investments across different asset classes (stocks, bonds, real estate, etc.) can help mitigate the impact of unsystematic risk. Different asset classes may respond differently to market events. Where one asset starts to go down another might start to go up and the fall and rise of these assets might be at different severity allowing you the flexibility to deploy risk management strategies to maximise on the rising asset
Hedging: Using financial derivatives like options and futures contracts can provide a way to hedge against specific systematic risks, such as currency fluctuations or interest rate changes.
Diversification in one of the big factors in reducing your risk. As the diagram shows the more diversify the portfolio becomes the less subject it is to unsystematic risk but you will eventually get to a equalising point where you still have to account for systematic risk.
It is important to note that diversifying your portfolio is not just simply investing in as many assets or industries as possible. This process needs to be a calculated application. If not, what can happen is that you fill your porfolio with random assets and stocks that end up having bad correlation between each other causing you to lose. When you buy on one asset you will lose on another constantly making it hard for you to find and edge/alpha
C Nicholas Downie
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