When it comes to investing, there are two sides of every coin.
On one side, you have the possibility of a return.
On the other side, you have risk.
Amateurs focus 100 percent of their energy on the possible return.
Seasoned investors know that the only way to evaluate ROI is by looking at it through the lens of risk.
On the surface, you might assume that risk is risk. But when evaluating an investment, risk should be categorized and broken down into specific types. And one of the simplest ways to think about investment risk is in terms of idiosyncratic risk vs. systematic risk.
In this article, I’ll explain what idiosyncratic risk is, what systematic risk is, and how the two come into play when evaluating different deals or investments.
Idiosyncratic risk, also known as specific risk or unsystematic risk, is a form of investment risk that is endemic to an individual asset (such as a company’s stock). It can also refer to risk that’s specific to a group of assets (like a particular sector of stocks), or even a specific asset class (such as real estate investment risks like mortgage-backed securities). Idiosyncratic risk is the opposite of systematic risk, which I’ll discuss in the following section.
Many people find it surprising that idiosyncratic risk actually accounts for the majority of an individual stock’s variation over time (as opposed to market risk). In other words, it’s micro factors related to each stock that typically cause fluctuations in price over time – not macro trends related to the overall health of the economy or collective changes in investor attitudes.
Examples of idiosyncratic risk factors for an individual stock include:
Every stock or investment faces idiosyncratic risk. Sometimes these risks are higher and sometimes they’re lower. (And they fluctuate on a daily basis.) However, if you want a recent example, look no further than LendingClub Corporation.
Back in the spring of 2018, LendingClub was accused by the Federal Trade Commission (FTC) of using deceptive business practices with borrowers. This included questionable tactics in relation to fees, as well as intentionally debiting money from client accounts without prior authorization. After the FTC brought the hammer down, LendingClub’s stock price dropped by 15 percent virtually overnight. This, combined with turnover in the C-suite, led to a period of heightened idiosyncratic risk that kept investors away.
An even more recent example is Peloton Inc., which produces at-home fitness equipment. From September 10, 2021 to January 20, 2022, the company’s stock price plummeted by almost 80 percent. But it wasn’t because of a macro decline in the stock market. Instead, the decline happened because its customers stopped working out from home as much as they did during the height of the pandemic and many returned to gyms. This decline in demand forced the company to halt production, which subsequently elevated idiosyncratic risk and caused the stock price to drop.
It’s not just individual companies that face idiosyncratic risks.
As mentioned, entire industries can too.
For example, if there’s a major foreign policy issue that prevents the importation of coffee beans into the United States, every company that relies on a global supply chain would be negatively impacted. However, this would have little-to-no impact on a restaurant that serves burgers and fries. That’s the definition of idiosyncratic risk – it’s isolated.
Now that I’ve covered idiosyncratic risk, let’s explore systematic risk and what makes it unique and different.
On the most basic level, systematic risk refers to macro risk across an entire market or market segment. It’s also referred to as market risk, volatility, or undiversifiable risk. In other words, it impacts the entire market, not just a single stock or industry.
When building an investment strategy, you can’t just pay attention to idiosyncratic risk. You must also account for the threat of systematic risk. Unfortunately, this form of risk is much less controllable, and the stakes are often much higher.
Systematic risk is unpredictable and can never be completely avoided. It can, however, be mitigated through proper diversification and strategic allocation.
A perfect example of systematic risk would be the onset of the COVID-19 pandemic in the United States. On February 14, 2020, the S&P 500 was at 3,380. But within just four weeks, it had plummeted to 2,304 – a 31 percent drop. It didn’t matter if the stock was a blue chip company like Coca-Cola or Amazon, or a tech startup in Silicon Valley, prices were affected across the board. As an investor, a declining portfolio had nothing to do with picking and choosing the wrong stocks. It had everything to do with a massive market downturn.
While you can’t typically pick your way out of systematic risk, there are ways to manage around it with proper diversification. One option is to diversify across different asset classes (not just within the same asset class). This could include investing in stocks, fixed income, real estate, precious metals, and cryptocurrency. In doing so, you lessen the impact of systematic risk and allow your portfolio to offset losses in one area with gains in other areas.
Risk is never something investors want to deal with, but it’s a reality of every single investment, regardless of the market, asset class, or investment strategy. The underlying objective is always to reduce risk as much as possible while increasing the chances of enjoying a high return.
As you can see, both idiosyncratic risk and systematic risk come into play when building a portfolio. If you can learn how to control what you can control and insulate yourself against the unpredictable risk that you cannot control, you’ll do better than most.
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