Updated: 4 days ago
In this post, we'll take a closer look at risk and what that means for your portfolio. Specifically, unsystematic risk is risk that can be diversified away whereas systematic risk is risk that cannot be diversified away.
Unsystematic risk is risk that is unique to a specific company or industry. It is assumed that unsystematic risk can be reduced or even eliminated through diversification. In other words, don't hold all your eggs in one basket.
For example, say you invest 100% of your portfolio in FB. If an event happens that affects FB directly (e.g. the company misses earnings) or an event happens that affects the broader tech industry in general (e.g. regulatory action), then your portfolio would be significantly impacted. Now say that you hold a well-diversified portfolio, where FB only represents 1% of your holdings. In this case, you would be affected a lot less by such events.
Systematic risk is risk that is inherent to the entire market, reflecting the impact of economic, geopolitical, and/or other market factors. Systematic risk cannot be diversified away.
For example, say you hold a well-diversified portfolio, but then an adverse event, such as the COVID-19 outbreak or the Russia-Ukraine war, happens. In this case, it doesn't matter how diversified your portfolio is, you will still be significantly impacted since the market as a whole is impacted.
Beta quantifies how sensitive an asset is to systematic risk. The higher an asset's beta, the more it will move in response to broader market movements.
It's important to understand unsystematic vs systematic risk as you construct your portfolio. In general, you want both types of risk to be within a range that you are comfortable with.
As mentioned before, a well-diversified portfolio can generally mitigate unsystematic risk. Within your equities portfolio, you might want to diversify across different types of companies, industries, and sectors. Within your broader portfolio, you might want to diversify across different asset classes, such as stocks and bonds.
As for systematic risk, we've already established that it cannot be diversified away. So how can we mitigate it? Well in this case, you need to look at the total beta of your portfolio and make sure it's within an acceptable range.
For example, say you calculate the total beta of your portfolio to be 1.5. This means that your portfolio will move 1.5x more than the market on average. So if the market is up 1%, your portfolio should be up 1.5%. If the market is down 1%, your portfolio should be down 1.5%.
If your portfolio beta is too high, you can take steps to reduce it. The simplest way would be to hold more cash. Cash has a beta of 0, therefore, holding more cash will reduce your overall portfolio beta. You can also swap some of your high beta holdings for securities with lower betas. There are also more sophisticated strategies (which we won't get into in this article), such as shorting and options, both of which can be used to offset your overall portfolio beta. But beware that these strategies will introduce other kinds of risk into your portfolio.
Some of you might have a higher risk tolerance and, therefore, accept a higher level of risk. For example, you might be comfortable with a larger portion of your equities holdings being in tech stocks because tech stocks have the potential to outperform the broader market. You might also be comfortable with a higher portfolio beta because, again, there is a higher chance to outperform the market. Just understand that this could also lead to larger losses than the broader market.