Risk: Systematic Risk vs Non-Systematic Risk

This is an advanced level topic – you may want to skip this post if you are just finding your feet with respect to finances! It assumes a basic understanding of portfolio diversification…

ChasingTheMarketsOrRisk.jpgWith respect to any given stock market there are two types of risk (which is another word for variance according to Modern Portfolio Theory): 1) Systematic Risk and 2) Non-Systematic Risk. Systematic risk is the general ebb and flow of the market – kind of like the tendency for all stocks to get dragged down or move up in tandem at the same time to a certain degree.  For example, the 1987 market decline was a Systematic event in that it really didn’t matter what you owned, it probably went down.  Is it warranted? Yes and no, but a main thing to consider is that nothing probably happened to any one stock to make it lose value in and of itself that day, but rather there was a general expectation or fear of a downturn in the economy linked to the market that caused everything to move. SYSTEMATIC RISK CANNOT BE DIVERSIFIED AWAY.

Non-Systematic risk CAN be diversified away. The best way to describe it is to build an analogy. Let’s say you owned one stock – if that company went bankrupt you will have lost 100% of your portfolio. If you owned 100 stocks, and 1 comany went bankrupt you would have lost 1% of your portfolio. On the flip side, what if that one company doubled in value? You either doubled your money or only gained a measley 1% if you held 1 stock or 100, respectively.  So this analogy builds a case against diversifying too much, but making sure you diversify a little. Non-Systematic risk is like the individual risk associated with the company linked to the stock – if it goes bankrupt – that is non-systematic risk and has nothing to do with the general ebb and flow of the market overall.

So, I mentioned that non-sytematic risk can be diversified away. It is generally debated as to how many securities you need to hold to get rid of non-systematic risk. You see, just as one company might go bankrupt, one company in your portfolio might double in value.  And one company might increase by 25% and one might decrease by 25%. So most recent research papers tend to think that 15-20 securities is enough to get rid of non-systematic risk. They suggest that trying to diversify by adding more securities than that is pointless as you may be adding stocks that do not have as rosy a prospect as the initial 15 or 20.  They further argue that for those that over-diversify by having 100 securities from the same market have bought alot of garbage for the sake of diversifying and will not reap the same long term returns as someone who has been more picky with their money.

Since it is agreed that non-systematic risk can be diversified away, and systematic risk cannot – it is plain to see that the goal for a rational investor is to do just that.  So the debate is really how many securities do you need to eliminate non-systematic risk? For now, I would tend to agree that 15-20 is optimal within any given market to eliminate non-systematic risk.  Anything beyond that and you are buying “filler” and reducing your long term rate of return – truly an irrational goal! :)

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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