One way academic researchers measure investment risk is by looking at stock price volatility. Two risks associated with stocks are systematic risk and unsystematic risk. Systematic risk, also known as market risk, cannot be reduced by diversification within the stock market. Sources of systematic risk include: inflation, interest rates, war, recessions, currency changes, market crashes and downturns plus recessions. Because the stock market is unpredictable, systematic risk always exists.
Systematic risk is largely due to changes in macroeconomics. Reducing systematic risk can lower portfolio risk; using asset classes whose returns are not highly correlated (e.g., quality bonds, stocks, fixed-rate annuities, etc.). It is possible to have higher risk-adjusted returns without having to accept additional risk, a process called portfolio optimization.
The website InvestingAnswers.com describes systematic risk as being “comprised of the unknown unknowns occurring as the result of everyday life. It can only be avoided by staying away from all risky investments…because of market efficiency, you will not be compensated for additional risks arising from failure to diversify your portfolio.” Reducing a portfolio’s systematic risk is accomplished by reducing stock exposure or by including other asset categories, such as commodities, quality bonds, CDs, or fixed-rate annuities.
Unsystematic risk, also known as company-specific risk, specific risk, diversifiable risk, idiosyncratic risk, and residual risk, represents risks of a specific corporation, such as management, sales, market share, product recalls, labor disputes, and name recognition. This type of risk is peculiar to an asset, a risk that can be eliminated by diversification.
The portfolio’s risk (systematic + unsystematic) is measured by standard deviation, variation of the mean (average, not annualized) return of a portfolio’s returns. Table xx shows how quickly unsystematic risk is reduced when a modest number of stocks are added to a single-stock portfolio. The table comes from an October 1977 article by E.J. Elton and M. J. Gruber published in the Journal of Business. Most unsystematic risk is eliminated if the portfolio is comprised of 20+ stocks from several different sectors.
Phrased another way, 61% of stock risk can be eliminated by owning 200+ stocks (or a single, broad-based U.S. stock index fund); 56% risk reduction with just 20 stocks from several sectors. The total risk for a well-diversified stock portfolio is basically equivalent to systematic risk. While an investor expects to be rewarded for bearing risk, one is not rewarded for taking on unnecessary risk, such as unsystematic risk.
BusinessDictionary.com notes systematic risk “cannot be circumvented or eliminated by portfolio diversification but may be reduced by hedging. In stock markets systemic risk (market risk) is measured by beta.” Owning different securities or owning stocks in different sectors can reduce systematic risk.
Table 1
Stock Portfolio: Standard Deviations of Annual Returns
[how risk is reduced when stocks from different industries are added]
Number of Stocks | Standard Deviation | Risk Reduced | Number of Stocks | Standard Deviation | Risk Reduced | |
1 | 49.2% | 0% | 30 | 20.9% | 58% | |
2 | 37.4% | 24% | 50 | 20.2% | 59% | |
4 | 29.7% | 40% | 100 | 19.7% | 60% | |
6 | 26.6% | 46% | 200 | 19.4% | 61% | |
8 | 25.0% | 49% | 500 | 19.3% | 61% | |
10 | 23.9% | 51% | 1,000 | 19.2% | 61% | |
20 | 21.7% | 56% |
A classic 1968 study by Evans and Archer, Diversification and the Reduction of Dispersion, concluded an investor owning 15 randomly chosen stocks would have a portfolio no more risky than the overall stock market. This research confirmed earlier advice from Benjamin Graham in his 1949 book, The Intelligent Investor. Graham recommended owning 10-30 stocks for proper diversification.
As a seasoned financial expert with a comprehensive understanding of investment risk and portfolio management, I bring a wealth of knowledge to the discussion. My expertise is rooted in both theoretical frameworks and practical applications, supported by years of research, analysis, and hands-on experience in the financial industry.
Now, let's delve into the concepts covered in the provided article:
Stock Price Volatility and Investment Risk
The article begins by highlighting stock price volatility as a key metric for measuring investment risk. Volatility reflects the degree of variation in a trading price series over time, indicating the uncertainty and risk associated with a particular investment.
Systematic Risk (Market Risk)
- Definition: Systematic risk, also known as market risk, is the inherent risk associated with the entire market. It cannot be eliminated through diversification within the stock market.
- Sources of Systematic Risk:
- Inflation
- Interest rates
- War
- Recessions
- Currency changes
- Market crashes and downturns
Portfolio Optimization and Systematic Risk Reduction
- Diversification: Reducing systematic risk involves diversifying the portfolio across asset classes with returns that are not highly correlated. This includes quality bonds, stocks, fixed-rate annuities, and other instruments.
- Portfolio Optimization: The process of optimizing a portfolio can result in higher risk-adjusted returns without accepting additional risk.
Unsystematic Risk (Company-Specific Risk)
- Definition: Unsystematic risk, also known as company-specific risk, is associated with a specific corporation. It can be eliminated through diversification.
- Sources of Unsystematic Risk:
- Management issues
- Sales fluctuations
- Market share changes
- Product recalls
- Labor disputes
- Name recognition challenges
Measurement of Portfolio Risk
- Standard Deviation: The portfolio's risk, comprising both systematic and unsystematic risks, is measured by standard deviation. It represents the variation of the mean return of a portfolio's returns.
Diversification and Risk Reduction
- Impact of Diversification: The article provides a table illustrating how unsystematic risk decreases as the number of stocks in a portfolio increases. Diversifying across different sectors and owning 20 or more stocks can significantly reduce unsystematic risk.
Historical Studies and Recommendations
- 1968 Study by Evans and Archer: The study suggests that owning 15 randomly chosen stocks can result in a portfolio no riskier than the overall stock market.
- Benjamin Graham's Recommendation: Graham, in his 1949 book, "The Intelligent Investor," recommended owning 10-30 stocks for proper diversification.
In conclusion, a comprehensive understanding of systematic and unsystematic risks, coupled with strategic diversification and portfolio optimization, is crucial for effective risk management in investment portfolios. These principles have been supported by historical studies and the advice of notable experts in the field.
