Risk awareness: systematic versus unsystematic
27 August 2014
Systematic risks (risks which cannot be eliminated through diversification) will command returns in excess of the ‘risk-free’ rate. Unsystematic risks, however, do not command such returns since they can be diversified away.
Unsystematic risk, also known as specific or diversifiable risk, is the type of uncertainty that comes through investing in a specific company or industry. Uncertainty, for example, due to a product recall or regulatory change, as these are pieces of news that affect certain stocks only or just one industry.
This risk can be reduced through diversification, that is owning stocks in different companies and different industries plus other types of asset such as bonds or property. A product recall or regulatory change shouldn't affect all those companies, industries or asset classes.
As we know, however, even a portfolio of well-diversified assets cannot escape all risk. It will still be exposed to systematic risk, also known as market or undiversifiable risk, which is the uncertainty that the entire market faces as a whole. Examples in this case include recessions and war, where the entire market would be affected, with the result that these risks could not be diversified away.
A recent, prime example of systematic risk was the Credit Crunch of 2007-9. Pretty much anyone invested in the market over that period saw the value of their investments fall, regardless of what they were invested in (a few exceptions included cash and the highest quality government bonds). As a consequence, investment across a range of asset classes would not have helped investors.
During another major event in the financial markets, the bursting of the ‘tech bubble’ from 2000 to 2003, however, diversification away from equities would have worked as most other asset classes increased in value while equities fell.
Over the long run, a well-diversified portfolio should achieve returns positively related to its exposure to systematic risk - in other words, investors face a trade-off between returns and systematic risk. Therefore, an investor’s returns correspond to their desired exposure to systematic risk and hence their asset selection. Investors can only reduce a portfolio’s exposure to systematic risk by sacrificing returns.
It should be noted that even if an investor stayed out of the market totally and invested in just cash or similar, they would face their money not growing and instead have the risk of it being eroded away by inflation, therefore being unable to fund their retirement and any other savings goals.
Matching beta and risk appetite
If an investor wants to know how much systematic risk a particular security, fund or portfolio has then they can look at its ‘beta’, which measures how volatile that investment is compared to the overall market or, to put it another way, its vulnerability to systematic risk. A beta of more than 1 means the investment has more systematic risk than the market, that is to say its price will be more volatile than the market. A beta of less than 1 means less systematic risk than the market or, in other words, less volatile than the market, while a beta equal to 1 means the same systematic risk as the market or that its price will move in line with the market.
Optimistic investors would more likely choose stocks or funds exhibiting high betas. Anyone pessimistic should choose an investment with a beta of less than 1. For example, if a fund has a beta of 0.6 and the market it is benchmarked against falls by 10% then the fund would only be expected to decline by 6%.