Published by Tyler Schlumpf
There are two main types of risk involved in investing: systematic and unsystematic risk. The first, systematic risk, is the general market risk all investors take when they buy stocks and bonds. Unsystematic risk, however, comes in many different forms. Specific company, credit and liquidity risks are just a few. While systematic risk cannot be diversified away, unsystematic risk can through diversified investments.
To earn a return, investors must take on risk; this is why the return on very low risk investments, or “risk-free,” is nearly zero. If an investor takes on more risk, they will expect more return. This isn’t always guaranteed, however, there has historically been a positive relationship between the amount of return an investor expects and the amount of risk they take. It is important to note that, because unsystematic risks can be largely diversified away, investors are generally not rewarded for taking those risks.
The biggest determining factor in what an investor can expect out of their portfolio in terms of risk (both systematic and unsystematic) and return is their asset allocation or their mix of stocks, bonds and cash. As we mentioned above, all investors take on systematic risk. Those that diversify their portfolio with different types of assets can help mitigate the unsystematic risks that concentrated portfolios may experience.
For example, take Richard, a fictitious investor who owns a small handful of stocks in the airline industry. We know he is exposed to systematic risks through his ownership of stocks. He is also exposed to significant unsystematic risks as well. Since he only owns a concentrated portfolio in one industry, he is taking on company specific risks, industry risks and asset allocation risks. What if the price of oil sky rockets? More than likely, the airline industry, along with his portfolio, would be impacted adversely. In addition, his concentration in stocks without any bonds contributes to the overall unsystematic risk as well.
Now, let’s say Richard meets with his financial advisor who promptly points out the risks he is taking and they begin to create a diversified portfolio of long term investments. The first step the advisor may take is to determine the return Richard needs to meet his goals and then set about building asset allocation models that will help him pursue these goals without taking on too much unsystematic risk. His advisor may start by adding bonds to the portfolio to help reduce the asset allocation risks Richard is taking by only investing in stocks. They may then look to diversify his stocks away from a few airline companies to reduce his company-specific and industry-specific risks.
The advisor may do all of these things through a diversified investment, such as a mutual fund and exchange traded fund (ETF). These diversified investments typically have hundreds, if not thousands of securities in them, thereby helping to lessen the unsystematic risks. By using broad, diversified mutual funds and ETFs, the advisor can help Richard invest in many stocks and bonds with exposures to more than just the airline industry. A portfolio of diversified investments, while it will not guarantee against losses, can help mitigate the unsystematic, or unrewarded, risks investors take.
A diversified portfolio is a lot like a house. It has a foundation, bathrooms, kitchen, bedrooms and various other types of rooms. An undiversified portfolio is similar to a house made entirely with bathrooms. Some may be a full bath or a half bath, but in the end, it is a house completely full of bathrooms that function almost the exact same way. In both analogies, regardless of the “bathroom” house or the “diversified” house, a solid foundation is paramount. Building a portfolio without the foundation of a complete wealth plan is a lot like a house on a shaky foundation. Once the wealth plan and goals have been determined, the investor can go about “building rooms” to diversify the portfolio. What an investor decides to build on that foundation is entirely up to them. Now, a house full of bathrooms may work for a while, but where would one sleep or cook? Working with a professional wealth advisor may help investors determine exactly how many “bathrooms” their portfolio needs while making sure to put in that “bedroom” so the investor can sleep at night.