3 ways to eliminate unnecessary investment risks

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Remove all non-systematic risk possible.
Systematic risk is the risk of the entire market or asset class.

Are you deliberately taking unnecessary investment risks?

 

There’s one way to achieve your life goals which take both money and planning. You must create – and stick to – a financial plan! No financial plan will ever call for taking unnecessary investment risks.

There’s a big difference between necessary risks and unnecessary risks. Driving to work in the morning is a risk, but a necessary risk.

It’s unnecessary to drive 100 miles an hour to get there. Doing so only increases the chances of bad stuff happening!

When it comes to investing, some risks are obviously required. Those are the necessary risks, like driving to work. Those risks allow you to achieve the returns of an entire asset class, effectively driving the financial planning results you need.

Most investors purposely take unnecessary risks. They buy and sell individual stocks and bonds. Financial planning is hard enough already. There’s no reason to take unnecessary risks.

Once you understand what risks are necessary – and which are not – you’ll find a much higher level of financial satisfaction with your planning. You’ll also sleep better at night!

 

What is non-systematic investment risk?

 

Unfortunately, most investors don’t understand the Efficient Market Hypothesis. They naively take unnecessary risks by investing in individual stocks or bonds.

This risk is called “non-systematic risk”. It creates greater investment volatility and a higher likelihood of not earning the returns of an entire asset class.

Take for example, Apple. Apple’s stock performance is affected by how it’s market sector (technology) is performing. Apple is also affected by how its asset class (large cap growth) is performing.

More importantly, if you own shares of Apple, there is a specific (non-systematic) risk associated with Apple stock. This is because Apple’s stock is also affected by its own set of business circumstances.

 

Factors which drive a stock’s performance

 

Apple’s profitability, financial strength, product innovations, and future prospects all affect it’s stock price. Apple also has specific risks from things like government regulation, currency fluctuation, lawsuits, and product innovation challenges.

There’s a risk that Apple’s tax obligations will change. Apple may experience tightened credit requirements, and that’s a risk specific to Apple. Apple may even launch a faulty product – and there’s clearly risk to the stock price if that happens.

We call these company specific risks non-systematic. They’re specific to Apple, not all large cap growth stocks.

Can you make money by investing in Apple? Of course! The real question is, “are the extra risks and volatility you expose your portfolio to worth it?”

If I take additional investment risks, I should be compensated for them with additional returns! Sadly, these risks don’t consistently compensate investors with excess returns above what an asset class will achieve on its own.

You can experience good fortune and earn more than the asset class on a whole. The problem is, you’re far more likely to endure greater volatility in the process and still fall short of the broad market returns.

The flip side of non-systematic risk is systematic risk. I’d far rather get a return on my money with less risk by diversifying into investments which own Apple and stocks like Apple. That keeps my personal investment risk as low as possible, yet allows me to own a piece of the company (and all companies like it).

 

What is systematic risk?

 

Smart investors only expose their portfolios to the minimum risk necessary to achieve their financial goals. That risk is called “systematic risk”.

Systematic risk is the risk associated with an entire asset class, such as all US large company stocks or all short term government bonds. Systematic risk is the minimum risk required to achieve the asset class returns.

Rather than have risks specific to Apple, you would buy a broadly diversified mutual fund or ETF which invests in stocks just like Apple. A broadly diversified mutual fund will have much more consistency in the return and volatility variance than an individual stock.

Consistency is important from a financial planning perspective. With individual securities you can be wiped out overnight! There’s no consistency with that.

What if you owned a large chunk of Apple and the day you retire Apple gets sued, launches a bad product, and tax laws change unfavorably? Your entire retirement plan could be decimated overnight!

Rather than invest in individual securities, create your investment plan using entire asset classes. Asset classes do not have specific risk because it’s eliminated through broad diversification. Investing in several hundreds or thousands of similar securities is how you achieve broad diversification.

Over very long periods of time, the risk and returns of an asset class are more likely to reoccur and average out. This makes financial planning worthwhile rather than worthless.

 

And if you don’t believe me…

 

Just look at the following chart. If you’re buying individual securities, missing just the top 10% of performers cuts your stock returns by more than half!

 

Non-systematic investment risks can really cost you in the long run!
Eliminate non-systematic investment risk through broad diversification.

 

And what if you miss just the top 25% of all performers? You’ve now turned a positive 7%+ return into a 5% loss!

Is stock picking really worth it? How can you be sure you won’t miss the top performers? I’d argue trading stocks is a fools errand.

 

3 ways to eliminate unnecessary investment risk

 

So you’re finally ready to invest like the big dogs? Great! Here are three ways to eliminate non-systematic risk.

  1. Embrace the Efficient Market Hypothesis. Once you come to the realization that you cannot “beat the market”, you’ll find a much easier – more peaceful – investment experience. Markets are efficient. Stop dreaming of hitting the hot stock pick and move on to the fundamentals that actually work (and won’t stress you out as much).
  2. Understand the two types of investment risk:
    1. Non-Systematic Risk. The risk associated with individual securities. It can be diversified away by adding more similar securities to the portfolio.
    2. Systematic Risk. The risk associated with an entire asset class. It cannot be diversified away. It is the minimum amount of risk exposure you must tolerate in order to earn an asset class’ expected long-term returns.
  3. Invest only in broadly diversified passive mutual funds. Your mutual funds (and many ETF’s fit the bill as well) must be broadly diversified. Each fund should have hundreds of individual securities which removes the unnecessary non-systematic risk.

 

Systematic and non-systematic risk in summary

 

If you agree that financial planning is the single best way to reach your goals, you must limit your investments to systematic risk only. There is no consistency in volatility, or returns, with individual securities… only randomness! This makes financial planning with any degree of accuracy at all, simply impossible.

Smart investors know that markets are efficient. Put simply, every security is worth exactly what it’s trading for at all times. There is no way to “game the system”. All securities are always fairly valued (unless you have inside information like Martha Stewart did).

If you believe in the Nobel Prize Winning efficient market hypothesis, you never take unnecessary risks. Rather, you diversify your investments broadly. This ensures you’re only exposed to the minimum investment risk required to reach your goals – the risk that’s systematic to an entire asset class.

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