Systematic vs unsystematic risk

Every investment action involves risks and returns. In general, financial theory classifies investment risks affecting asset values into two categories: systematic risk and unsystematic risk. Broadly speaking, investors are exposed to both forms of risk.

Systematic risks

also known as market risks, are risks that can affect an entire economic market or a large percentage of the total market. Market risk is the risk of losing the value of your investments due to factors such as political risk and macroeconomic risk, which affect the performance of the overall market. The impact of oil price wars and Covid-19 are examples of this. The response by the authorities has been to manage short-term challenges through quantitative easing and fiscal stimulus – both of which could bring new risks in the longer term. Market risks cannot be easily mitigated through portfolio diversification. Other common types of systematic risk can include interest rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk.

Unsystematic risk 

also known as specific risk or idiosyncratic risk, is a category of risk that only affects an industry or a particular company. Unsystematic risk is the risk of losing an investment due to a company or industry-specific hazard. Examples include a change in management, management fraud, a product recall, a regulatory change that could drive down company sales, or a new competitor in the marketplace with the potential to take away market share from a company. Investors often use diversification to manage unsystematic risk by investing in a variety of assets.

Not as efficient as we think

Efficient financial markets are less efficient than we think, often driven by inefficient artificial intelligence and algorithmic models, as well as by irrational human investors such as you and me. Whether it is models built by humans, or humans themselves, there are a number of biases at play in the markets. As humans, we are all wired differently based on our experiences, and therefore you may be more inclined to possess an optimism bias or a pessimism bias. I'm not suggesting that you should try and change these inherent biases, but we should be on the lookout to recognise our particular bias and the influence this has on our actions, or lack thereof. Transparency in the financial world is seen as a positive, and to a large extent I would be inclined to agree with this. Access to information however in the context of a volatile financial world that we've experienced in the last number of weeks can drive investors to behaviour which can encourage short-termism, which in turn may compromise long-term investment objectives.

A number of financial markets around the globe lost over 30% in value in the space of less than a month during March 2020. This created a lot of nervousness for investors, many of whom may have considered, or even worse, followed through by liquidating parts or all of their portfolios. How might this irrationality be extended if there was a mark-to-market or daily pricing model for our primary residence or business? It is possible that for many people, their homes would have lost similar values to listed equity markets over this time, and yet I don't believe people are considering selling their primary residence as a result. On the contrary, investors would probably be inclined to buy good assets when they are priced at a 30% discount.