When considering any investment, it is essential to recognise that without risk there is unlikely to be any return.
For example, while Treasury bonds are often recognised as the gold standard of investment, they can create a return because there is a risk that the government may default, no matter how small the chances. On the flip side, the risk of failure is relatively high with start-ups and technology companies; therefore, the potential return is greater.
In this article, we will look at what is known as systematic and unsystematic risk, how they might affect your investments and how you can reduce your exposure. While there are numerous specific issues to consider with any investment, they can all be split into these two groups.
Before we look at these two different types of risk in more detail, to put them in simple terms, they are defined as:-
Systematic Risk - This type of risk is inherent in entire markets, not specific to companies or individual investments.
Unsystematic Risk - This type of risk is specific to individual companies or investments and has no impact on the wider market.
While there are ways to mitigate some aspects of these risks, as with any investment, there will be a degree of systematic and unsystematic risks.
In theory, the concept of systematic and unsystematic risk is relatively straightforward, but it is helpful to put these into context with everyday examples.
There are many different types of systematic risk, but some of the more common include:-
As an investor, economic risk is out of your control, something which is controlled by governments and central banks, at least to a certain extent. Historically, economic risk can be specific to one country or, as we have seen in recent years, a global issue with the pandemic and the earlier financial crisis brought on by the collapse of the US subprime mortgage market.
In context, if an economy fell by 10% from $1 trillion to $900 million, the overall economic pie is reduced. So, a sector with a previous 10% share of the economy would see this fall in value terms from $100 million to $90 million (on a like-for-like basis). This would trickle down to individual companies that would see their turnover and profits fall, impacting share prices.
The topic of interest rates is never far from the headlines, whether economies are booming or struggling. Interest rates directly impact the amount of money in circulation and, therefore, the amount of money to spend. As a company, an increase in interest rates will also increase the cost of borrowing, which can significantly impact cash flow and growth. As this increased cost of borrowing is across the board, it is, to all intents and purposes, unavoidable for companies that use debt as part of their operations.
Movements in interest rates will also impact consumer spending, which filters down into company turnover and profits. The impact is spread across the entire economy, which is why interest rates are used as a relatively blunt tool to try and control economies.
You rarely see double-digit inflation in the Western world, but we saw this in the UK recently. It significantly impacts the cost of living unless wage rises can match inflation and maintain relative spending power. If individuals and companies cannot afford the increased cost of goods and services, this reduces company turnover, which impacts margins and profitability.
While we have identified some of the threats from inflation, it's crucial to appreciate the need for a degree of inflation. This is healthy for economies, prompting growth, increased spending, employment, wage rises, and enhanced profits. This is why the Bank of England has an inflationary target of 2%, which they believe is positive for the economy.
It is easy to assume that currency risks are irrelevant to all of us or every investment, but this is not the case. Businesses will import and export certain products and materials, sell services overseas and even something as simple as the price of oil (denominated in dollars) will be impacted by currency risk. So, while it may be easy to discount the threat of currency risk, fundamentally, it is enormous and one of the foundations of economies and trade.
As unsystematic risk is relevant to a particular sector or company, many examples exist. Some of the more common include:-
This is a risk which is specific to a particular industry or even company. For example, a company working with cutting-edge technology may bring out a service significantly better than its competitors. This gives them a leading edge until one of their competitors brings out an improved service. This is why the risk/reward ratio is relatively high in the high-tech sector because there are huge risks as technology advances.
There are many different examples of financial risk in the investment market, often related to how a company operates, its structure and its funding profile. If a company is highly leveraged, borrowing money to invest in the business, this is likely to be productive when economies are doing well, but what happens when they turn down?
If demand starts to fall and borrowing costs rise, this would put pressure on cash flow, potentially leading to job cuts and reductions in turnover and profitability. For a stock-market listed company, this would likely lead to pressure on the share price and a reduction in the value of your investment.
The subject of management risk is interesting because it can be something of a double-edged sword. For example, if you look at someone like Elon Musk, probably one of the best business minds in the world, he can attract controversy. Loose cannon, a free spirit, call him what you want, there is a risk that he might make a controversial comment which could impact the brand/image of a company.
For example, while leading electric car company Tesla from a start-up to a company worth more than $1 trillion, there were occasions when he felt the wrath of the regulators. On one such occasion, he posted about making a potential takeover bid for Tesla, sent out via social media. Neither the board nor the regulator had cleared this comment, and ultimately the regulator became involved. A sharp spike in the share price very quickly reversed as it became apparent a bid was unlikely to emerge. While an extreme element of management risk, it does reflect some of the unknown challenges.
Each industry is regulated to a certain extent, some much more than others; consequently, they all carry a degree of regulatory risk. Therefore, if you invest in a particular sector, you are taking on board an element of regulatory risk. It may be that the potential rewards appear to be greater than the potential regulatory risks, but this can change very quickly.
A topical example is cryptocurrencies, which emerged from nowhere and gained traction with many investors, but there were no regulatory controls. This led to a degree of market manipulation, and then the regulators became involved, creating a more structured trading environment. This impacted individual currencies and trading platforms. There was also a knock-on effect on other companies operating, directly and indirectly, in this space.
This is another area where these two different types of risk vary significantly. For example, when investing in the stock market, you are exposed to a wide range of systematic risks over which you have no control. One of the main characteristics of systematic risk is the inability to reduce this by diversification. For example, if you were to diversify your investments into another stock market, there would still be a degree of systematic risk there - economic, inflation, interest rates and currency, for example.
If we turn to unsystematic risk, there is also a degree of this with any investment, as with systematic risk. However, the key here is that diversifying your portfolio mitigates and effectively spreads the risk. In the above example, if you bought Tesla shares and another company without a connection to Elon Musk, you have mitigated the risk of your investment being impacted by any comments from Elon Musk.
This is the same when investing across companies in the same and different sectors. How you structure your diversification is up to you, but if done correctly, it will reduce the impact of unsystematic risk.
When looking at any investment, it's essential to look at the risk compared to the potential rewards, taking in systematic and unsystematic risk. You may come across scenarios where investing in a particular company seems right, but the economy is unlikely to perform well in the short term.
If you see scenarios where the potential reward seems higher than the potential risk, in relative terms, then that may be worth considering. Conversely, if you see situations where the potential reward seems relatively low compared to the potential risk, that's a different scenario.
Firstly, taking a long-term view of your investments is vital, as the greatest risk can often be being out of the market and deciding when to get back in. There will be short-term issues to consider; you may change your opinion of a particular market or share and decide to look elsewhere. Taking a broader view, you might think the economy is about to struggle, and it is time to revert to cash. It's not difficult to see that what may seem like a relatively simple decision on the surface quickly becomes more complex!
This is where I come in, with my expertise and experience in investment, broader finances and the ability to look at your situation with fresh eyes. Sometimes, we may look at a particular area of your finances in isolation, but any decisions must also consider the broader context. This brings in the topic of diversification, which can be achieved by investing across a number of shares (some believe that anywhere between 10 and 20 shares are sufficient) or looking towards collective funds.
The main attraction of collective funds is the instant source of diversification through the underlying portfolio. You don't need to buy every individual share, watch it or trade them; the fund managers will do this. So, whether through a broad range of investments or an investment in collective funds, there is an opportunity to reduce unsystematic risk.
In essence, you can't control systematic risk, but you can diversify your investments to reduce the impact of unsystematic risk. With that in mind, it is essential to monitor the prospects for individual shares (or collective funds) and broader issues such as the economy, currency and inflation, to name but a few.
Whether you take a top-down approach, looking at the systematic risk and then the unsystematic risk, or vice versa, these are issues that should be central to your short, medium, and long-term investment strategy.
If you would like to discuss your investments in more detail or have specific questions about systematic and unsystematic risk, please get in touch with me.