Investment prices / values tend fluctuate in line with changes in the world around us. These price fluctuations are driven by changing risks, which can be thought of in 2 broad buckets: Systematic and Specific.
This refers to the risks underlying the whole market / economy, incorporating things such as:
Interest rate changes
Foreign exchange rate changes
Government policy / regime changes
Changes in the business cycle
Investors usually manage systematic risk as much as possible by diversifying their portfolios across various geographies and asset classes. This is because different asset classes act differently in response to given events.
For example, if you own UK stocks and worry about the impact of Brexit - a systematic risk for the UK stock market - you would do well to diversify your portfolio by buying stocks, bonds or real estate in other countries.
Specific risk is also known as idiosyncratic risk or unsystematic risk. While systematic risk is related to the possibility of a whole market falling under hard times, specific risk refers to the probability of one specific company or industry struggling due to a reason which only affects that company or industry.
For example, the risk that oil companies will struggle in the future due to increasing usage of renewable energy and new entrants to the market, is specific to the oil industry. Alternatively, the risk that management of a company is involved in some kind of scandal which affects the value of the company is again specific to a single company and would not affect other companies.
Investors usually manage specific risk by limiting their overall exposure to any one company or industry. While this may limit the returns you could earn in the event that one of the companies or industries you are invested in does really well, it also limits the risk of losing money due to some kind of unforeseen fallout involving a company or industry.
Putting all your money in Tesla shares might sound like a good idea, but in practice it’s probably not the wisest approach to managing your wealth in the long run. ETFs and other funds offer an easy way to invest in a diversified portfolio of companies, if you don’t want to pick your own!
Specific risk is a broad term, covering a number of risks such as:
Liquidity risk: when you can’t buy or sell something in the market because it’s difficult to find someone else to buy from or sell to at a reasonable price
Credit risk: when the company or industry carries too much debt, leading to one or more companies going bankrupt
Concentration risk: when too much of your portfolio consists of a single company or industry
Management / employee risk: when management / employees don’t do a very good job of running a company
Disruption risk: when a company or industry comes under threat from a new business which disrupts their existing business model
Managing external risks - its not easy, but diversification can be 🔑
Specific risk can be minimised by diversifying your portfolio. A very general rule of thumb when it comes to diversifying a stock portfolio is to hold 20+ stocks, selected from a range of industries and stock markets. An alternative would be to invest in a well-diversified fund or ETF, if the thought of researching and being up to date with so many individual companies feels unnerving to you.
Systematic risk is harder to eliminate - the best you can do is to diversify across a range of asset classes in a number of different countries. But even then, a global recession, war, or other similar crisis would still likely lead to some small losses. While this is the risk you take in order to grow your wealth, its worth bearing in mind that even holding cash is still exposed to inflation risk (the chance that prices increase and you are able to buy less with a given amount of money over time). Similar to risks in general life, systematic risk is something which we can’t really escape - but we can do quite well by simply being aware of it around us and trying to manage it the best we can!
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.
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