Why You Cannot Stop Systematic Risk

Risk is good. Systematic risk is terrifying and normal. No-one likes to see virtually every stock in their stock portfolio drop 20/30/40% in a short period of time. Sadly if you invest in stock markets, you should be prepared for investors to panic sell when an economic disaster appears on the horizon. This is always a hard lesson for new investors to learn, when systematic risk takes over, switch your computer off and go for a walk. Rational behaviour will have gone out of the window.

Table of Contents

Risk is good. Systematic risk is terrifying and normal. No-one likes to see virtually every stock in their stock portfolio drop 20/30/40% in a short period of time. Sadly if you invest in stock markets, you should be prepared for investors to panic sell when an economic disaster appears on the horizon. This is always a hard lesson for new investors to learn, when systematic risk takes over, switch your computer off and go for a walk. Rational behaviour will have gone out of the window.

Takeaways
  • Understand systematic risk

  • Why you cannot stop it

  • How to mitigate it

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What is systematic risk?

It is a risk which affects everyone, and is a key part of equity risk. It is not a specific risk which affects a particular sector or a profit warning which affects a specific company. So if the oil price drops into negative pricing, as happened in 2020, then the oil sector companies will all be in the red.

Other sectors will be fine though: how would a drop in the oil price affect healthcare companies? Very little directly. Because systematic risk affects everyone, it cannot be diversified away.

Examples of systematic risk of recent years were the 2008 financial crash and the 2020 Coronavirus pandemic. In both cases, every company was affected directly by the crash in demand. If there are no clients to serve, no company will make profits.

Relationship between risk and reward

If you want to make money you have to take a risk. Why? Because if there was no risk, there would be no reason for compensating you. If a trustworthy friend asked you for £10 in the pub, would you charge them interest? Probably not.

Although I appreciate charging interest to a close friend would raise moral questions, the fact you trust them is probably the most important consideration.

The level of risk affects the level of reward.

Why are German 10y Bunds and US 10y Treasuries valued for their safety? Because we trust their governments. On the other hand if a friend asks you for money to invest in their start-up, you would be foolish not to ask for some equity, due to the risk of it failing. Remember, the riskier the opportunity, the more you should be rewarded.

How can you reduce systematic risk?

If you cannot stop downside risk, you can certainly do something to mitigate the overall effect on your portfolio. A margin of safety would be a good start: ensure you perform fundamental analysis. Although systematic risk affects every stock, some may suffer more than others.

Therefore some form of diversification and portfolio protection would help. For example, limiting your exposure to one sector of the equity market (e.g. technology / healthcare) to 30% of your overall portfolio is sensible. Also limiting your exposure to one stock to 5% of your portfolio is good practice. If a stock performs well, such as Tesla stock in early 2020, then reduce your exposure back to 5% taking some profit in the process.

Reducing Systematic risk by taking some profit!

Finger on the trigger

For systematic risk to take hold, there needs to be a trigger. The Coronavirus inspired sell off of 2020 was an excellent example. Equity markets had reached all time highs and valuations were becoming eye-wateringly expensive. There were simply too many overvalued stocks. All the sophisticated investors were just waiting for a sell off. And then the world shut down.

Cue pandemonium, with all other classes selling off, even gold and US treasuries! You simply could not of escaped the sell off. This was an excellent example of systematic risk in operation, nothing was safe from being sold off, except cash.

Hit from the blindside

Frankenshock created a violent reaction similar to a systematic risk induced sell off

Occasionally an event will happen which will come out of nowhere and have large negative consequences. Within the investment world, this is called a Black swan event. Such an event is defined by its unpredictability, the volatile response by markets and the losses it normally creates.

An excellent example in recent memory was the Frankenshock of 2015. The removal of the CHF peg against the Euro, led to the largest move in a major currency since the first world war. The 30% move was so unprecedented that firms went bankrupt and others incurred huge losses.

The cunning plan failure...

Although traditional risk mitigation techniques such as using stop losses would have helped, the move was so large and quick, that many stop losses failed to work.

The Frankenshock is technically not a systematic risk, more sector and currency specific. Yet it is a good reminder that even the best laid (risk mitigation) plans do not always work in the face of a powerful and unexpected financial event.

Conclusion

You cannot stop systematic risk. You can mitigate the cost to you so as to ensure you are not wiped out and ensure capital preservation. Hindsight is a wonderful thing, but it pays to consider it. In the case of the Frankenshock, the ECB's bond buying program meant the Swiss National Bank could not possibly defend its peg anymore.

Many investors were unwise to expect the peg would always be in place. Sometimes the best way to avoid systematic risk, is by pure common sense. If there is a change in financial conditions, ask yourself who will be affected? Once identified you can par back, or even sell out of your investments to avoid the destruction that systematic risk brings.

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