In continuing my series on financial terms and ideas that are widely misunderstood, I thought it best to start the year off with a topic that is on everyone’s minds after this past year: Risk. No not the risk that you will run out of toilet paper (too soon?). I’m talking specifically about investment risk! It is not uncommon for me to hear a client say something to the effect of, “Am I taking too much risk?” or “Am I being risky enough?”. I think that it is important that we have a right understanding of the dictionary definition of investment risk, how we measure that risk, and how we should think about risk practically as investors.
Systematic vs. Unsystematic Risk
Investment risk can be broken down in to two broad categories labeled, systematic and unsystematic risk. Systematic risk is the risk inherent to any investment in the stock market. It can be thought of as, “the probability of a loss that is associated with the entire market”.[i] It is also referred to as “undiversifiable risk” or “market risk”. This type of risk is completely unavoidable and is not specific to one industry or investment type. The year 2020 provided us with the perfect example of systematic risk: The COVID-19 pandemic. The pandemic was a completely unforeseen event that took the market by storm. Some industries, like restaurants and retail, were hammered by the shutdowns and subsequent loss of revenue. Other businesses, like Zoom and Amazon, thrived during the pandemic due to the nation’s reliance upon their services while in quarantine. While systematic risk cannot be completely avoided, it can be mitigated by having a portfolio that is well diversified and contains holdings in each of the major asset classes (equity, fixed income, cash, real estate, etc.). Each of these asset classes will react differently to the inherent risk of the market as we saw in the COVID-19 example above. Other examples of systematic risk include interest rate changes, inflation, recessions, and wars[ii]
Unsystematic risk is also known as “diversifiable risk” or “specific risk”. It is the type of risk that is specific to certain industries or companies. For example, social media and similar tech companies are under fire from legislatures for antitrust concerns and worries about cybersecurity. This is a risk that is specific to those companies and/or the industry as a whole and can be avoided by reducing or eliminating one’s investments in those companies or industries. Of course, in this too there is a level of uncertainty. Oftentimes, events that affect very specific industries can also come quickly and without warning. One strategy for limiting unsystematic risk is, again, to have a well-diversified portfolio of holdings across asset classes and industries. You can learn more about unsystematic risk here.
How do you measure risk?
When we talk about investment risk, what we are really talking about is the probability that an investments’ actual gains will differ from the expected return[iii]. In other words, if we build a portfolio seeking to have an average return of 8%, what is the probability that our portfolio will give us a return above or below that target and if so by how much? How much volatility should we expect or, to put it in plain English, how much should we see our account value move up and down in any given year? The primary metric we use to measure the risk, or volatility, of an investment portfolio is standard deviation. What standard deviation tells us is how much we should expect our portfolio to deviate from its average return in any given year. A portfolio with a low standard deviation can be expected to stay the course with only slight deviations from its average. A portfolio with a high standard deviation can be expected to see wider swings in its returns both in outperformance of its average and underperformance. I hope to cover this in greater detail in a future blog post but for now I will leave you with this: The time to care about volatility and therefore standard deviation is not when you are young and have 30+ years until retirement. Volatility and investment risk in general becomes much more of a concern as you approach your retirement years and the need to withdraw funds to support your income rises.
How should I think about risk?
Risk is often thought of as the probability that an investor will lose money. For some, this is a perfectly accurate description of what risk means to them. For the investor in retirement, it is “risky” to allocate your retirement funds to a portfolio that will experience all the ups and downs of the market. By contrast, consider the investor that we spoke about in our last point. A young investor with many years to retirement faces a different kind of risk: Not accepting enough risk in the form of volatility and thus underperforming their investment goals. Being too risk adverse in your early years of investing can cause hurdles later in life that are difficult, even impossible, to completely overcome. Again, this is another topic that I hope to cover in greater detail in a future blog post. For now, I want to leave you with a final thought about investment risk.
While there is a dictionary definition of risk and formal metrics for measuring it, what is truly “risky” is dependent on your plans for the future and your current circumstances. As financial advisors, we help our clients take into consideration both the objective principles of investment risk as well as the subjective needs and goals of the client. This involves determining the investment return necessary to achieve those goals and balancing those needs with an appropriate level of risk.
I hope that you have enjoyed today’s installment of “A Wing and a Plan”! I am enjoying writing about the financial jargon that makes up the financial services industry and I hope that you are finding it to be valuable information. I would greatly appreciate any suggestions that you might have for upcoming posts in this series!