Whether you know it or not, the concept of risk can be broken down into two main classes; systematic and unsystematic risk. Systematic risk is market wide risk that is going to be applied to nearly all securities or stocks in the market. For example, systematic risk would be a terrorist attack that would affect the entire market no matter what industry or sector your trading in. This type of risk is completely unavoidable and cannot be managed or mitigated by investors because it is completely unforeseen. Unsystematic risk is risk that is specific to a particular company or industry. This could be risk to social media companies or mortgage companies in particular but don’t effect the entire market. This type of risk can be largely avoided by diversifying stock selection and underlying asset correlations.
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In this video, we are going to be talking about systematic versus unsystematic risk. This is a little bit more of a high-level concept, but I think that you guys are going to enjoy this video.
I’m going to try to keep it as short and sweet as possible. I know I could talk probably hours and days about portfolio stuff, but in this video, we’re just going to touch on these two basic concepts and go through them.
We all know that all investments have a risk. It’s safe to assume that all stocks have a risk as well. But did you know that there were different types of risk? Not all risk is the same. Most people think that all risk is the same.
It’s not true. There is some risk that you can avoid via diversification (and we’ll talk about those) and then other types of risks which are 100% completely unavoidable.
I bet you didn’t hear anyone say that recently, that you can completely have a risk that is 100% unavoidable, meaning you can't hedge it, you can't get rid of it, it's always there. That is the systematic risk.
Systematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, taxation, a shift in social, economic parameters, global security threats, etcetera.
For example, Black Monday in October 1987 was a systematic event in that almost all stocks fell in value on that single day. We could also say that a systematic event was 9/11.
No one had ever factored in the fact that two planes would fly into the World Trade Center, into the Pentagon, would crash in Pennsylvania. No one ever knew that. That’s a risk that is unavoidable, and it affects the entire market.
This type of risk (the systematic risk) is beyond the control of investors. Me or you or anybody, we can't control this, and it cannot be mitigated.
We have a unsystematic risk. Unsystematic risk is due to factor specific to an industry or a company, like product category, research, and development, pricing and marketing strategy.
If you owned one stock and if that company went bankrupt, you'd lose 100% of your portfolio. But what if you owned 100 stocks and that one company still went bankrupt? You would only have lost 1% of your portfolio.
You can see that this type of risk is avoidable, yet the market does compensate investors for taking such exposure. I would say that unsystematic risk would be a risk if you’re in let's say the aerospace industry or the cotton industry or you’re in the electronics industry or the computer industry or the oil and natural gas industry.
Those all have a risk in and of themselves that are different than every other industry out there. You can get rid of that risk and avoid some of that risk via diversification, buying a whole bunch of different securities that are not related to one another in any way, shape or form or have a minimal relation between them and that’s how you avoid that.
In portfolio theory, what we really talk about here is the fact that the number of securities you have in a portfolio, generally speaking… There is a max, and that’s called the efficient frontier which we will talk about in another video.
But generally speaking, the number of securities or the more stocks you hold in a portfolio, the less unsystematic risk you’re going to have in that portfolio, and you can see how this unsystematic risk feature here is going to decrease.
Risk is measured up and down on this sidebar here, and there's a certain level of systematic risk which is always present, and that's marked here by this A to B line, and you can see that this systematic risk is always present, and it’s present no matter how many securities we have in the portfolio.
We could have the most diversified portfolio on earth, but that still doesn't change the fact that on 9/11, two planes hit the World Trade Center and that terrorist attack was something that was completely unavoidable.
No one knew that was coming. But for unsystematic risk which is just specific to different industries and companies, you can avoid that risk and reduce your risk by diversifying the number of stocks you have, the industry, the sector, the country, etcetera.
Generally speaking, the more you have, the closer you’re going to get to just pure systematic risk, and that is always a good thing. You want to reduce as much risk in your portfolio as possible.
Hopefully, this video has been helpful to tell you guys more about systematic versus unsystematic risk. We've only touched the tip of the iceberg here when it comes to portfolio theory.
But as always, check out more of our videos at optionalpha.com. Thanks for watching and take a second just to share this video with any of your friends, family or colleagues on your favorite social network.