Unsystematic Risk and How to Reduce It

risk-managementInvesting in financial assets carries risk. Nevertheless, millions of investors put part of their wealth into stocks, bonds, and other asset classes. Investing in the markets obviously carries risk. In general, market risk can be broken into two parts: systematic and unsystematic risk.

Systematic risk is the risk you can’t eliminate. It is the risk taken when investing in the market. In addition to it, the unsystematic risk in an additional risk due to undiversified portfolio. A way to determine risk of a particular security, such as a stock, an investor can look up its Beta. A Beta of 1 means the stock is as volatile as the market, while a Beta above 1 means the stock is more volatile than the market. On the other hand, a Beta below 1 means the stock is less volatile than the market. Note that Beta is based on the past and can change.

How to diversify

To reduce unsystematic risk, an investor needs to diversify. Here arises a question: What is the right amount of diversification and which assets or asset classes should be included? Early work by an Economics Nobel Prize winner, Harry Markowitz, leads to a conclusion that most of unsystematic risk can be reduced with as few as 30 securities.

However, these can’t be any securities. For example, buying 30 technology stocks will not reduce unsystematic risk as these companies are in the same sector. Thus, for right diversification, it needs to be a right asset mix. Investments need to be spread among industries (such as technology, energy, banking, healthcare, and on), countries, and asset classes (stocks, bonds, commodities, etc.)

A relatively simple way is to diversify with the Index Funds that are available to the public. By purchasing domestic and international stock index funds as well as a bond fund, much risk gets diversified away as here an investor’s risk is spread among industries, asset classes (stocks and bonds), and countries.

Another way to go is to use Exchange Traded Funds (ETFs). These instruments trade on the market just like the stocks and offer a broad range of investment opportunities. There are ETFs that focus on specific regions (such as South- East Asia), countries (China), commodities (oil, silver, gold), industries (biotech), currencies (Euro), and assets (bonds). The offer is truly tremendous.

Hedging to reduce systematic risk

Systematic risk can also be reduced but not entirely eliminated. One way is to use options. For instance, an investor can purchase protective puts on the securities held in a portfolio. If the value of these securities drops, the put value will rise. There are a few issues, though. First, this may not be a perfect hedge, meaning the rise in put’s value may not offset the drop in securities. Second, buying options costs money. Third, options are for certain time only. Once they expire, you need to buy new ones to stay hedged.

There are also Inverse ETFs. Here it is possible to bet on markets falling. The rise in Inverse ETF can offset the drop in a portfolio. Also, note that some actively managed mutual funds will pursue hedging strategies. Moreover, for wealthy investors there are market neutral hedge funds that seek to eliminate market risk.

Whatever your investment goals are, don’t put all your eggs in one basket. Reduce risk by diversifying your holdings and considering hedging strategies. The current offering when it comes to mutual and index funds, ETFs, and hedge funds is quite broad. It is important to understand what you’re getting into by carefully reviewing prospectuses or fact sheets provided by those funds.

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