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Investment Portfolio Risk - Systematic vs. Specific Risk
Most individual investors (and unfortunately many financial advisors) haphazardly throw together bits and pieces of stocks, bonds, mutual funds and annuity products in an attempt to diversify their financial holdings and reduce investment risk. Incorrectly they assume that “more” holdings are automatically “better”, when in fact more may mean little more than a false sense of security.
In the context of creating a truly diversified investment portfolio, there are two primary types of risk associated with individual investment securities - specific risk and systematic risk. The creation of an “efficient investment portfolio” is based on several factors, including eliminating all “specific risk” or “non-systematic risk” (also called diversifiable, unique, unsystematic or idiosyncratic risk).
Specific risk is a completely unnecessary risk. Most investment portfolios are exposed to specific risk, yet most investors aren’t compensated with corresponding investment return because of the nature of specific risk.
Specific risk is the risk associated with individual investment securities. It’s unnecessary because it can be diversified away by adding more similar securities to the portfolio. The more securities added (similar in nature), the more the specific risk of an investment is reduced until you reach a point of diminishing returns (where added securities have no added risk reducing effect).
If you own shares of IBM, there is specific risk associated with that security. It fluctuates in value based on its own set of business circumstances like profitability, financial strength, product innovations and future prospects. IBM also fluctuates in value based on how its market sector (a grouping of other large technology companies) is performing.
If you owned 10 large technology companies, you’d begin to diversify away the specific risk associated with IBM. If you diversified into enough positions (many experts say 15 to 20 at a minimum), you would have an “asset class”.
An asset class is a group of similar securities - for example large companies, small companies or international companies. Asset classes do not have specific risk as it has been effectively eliminated through diversification. An asset class does however have “systematic risk”.
Systematic risk is the risk associated with an entire asset class once all specific risk has been eliminated. It cannot be diversified away (with the exception of long/short strategies which is beyond the scope of this article). Each asset class has it’s own systematic risk that one must endure to achieve the expected long-term returns of the asset class.
Each asset class has a historical “correlation” to another asset class, meaning some investment securities perform differently at different periods in our economic cycle. For example, in 2008 commodities like gold and oil fluctuated wildly both up and down in value. United States equity holdings floundered through the third quarter, then sank dramatically in the fourth quarter as commodities stabilized. Treasury bond prices tended to trend upward throughout the year as interest rates came down.
These are excellent examples of “non-correlation”. Asset class investments performed good or bad relative to each other, and although most asset classes ended lower in value in 2008, there were varying degrees of investment loss for each asset class. Consequently a well diversified portfolio including multiple asset classes and bond holdings performed better on average than their 100% equity counterparts.
To create a truly diversified investment portfolio, an investor must first remove all unnecessary (specific) risk associated with their investment holdings. This means ONLY accepting the systematic risk associated with an investment, and embracing it as a means to an end.
To further reduce portfolio risk through diversification, an investor must combine several asset class investments with non-correlative qualities in a portfolio balanced to the investors desired risk tolerance. This concept is based on Modern Portfolio Theory - or an effectively proportioned mix of non-correlative asset class investments. Modern Portfolio Theory serves as an industry wide accepted model for rational investment portfolio decision making.
Generally speaking, a minimum of 6 asset classes could be combined into a statistically significant diversified portfolio. 6 asset classes each holding 20 securities (minimum) makes for a LONG portfolio statement from your custodian! That’s 120 securities in your portfolio, and it’s quite unnecessary with the advent of no-load mutual funds and exchange traded funds. You could hold 120 positions and monitor them - fumbling around a re-balancing program, or hold 6 positions (8 to 12 is more preferable) making re-balancing your diversified portfolio allocation much simpler, and invariably more precise.
Once the specific risk is removed and non-correlative asset classes are combined into a balanced portfolio, an investors desired long term return level should in theory be purely correlated with each unit of risk they’re willing to accept. When only systematic risk remains, and full diversification among several asset class investments has been accomplished - the saying “the greater the risk, the greater the reward!” should hypothetically hold true over long periods of time.
So before beginning any investment program, consider carefully the types of risk you’re exposing your portfolio to. There’s no need to take unnecessary risks with your investments. It is your financial future after all!
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