FINANCIAL TOOL
Unsystematic Risk
While we want to eliminate the paralyzing fear of loss, we also want to act prudently to avoid unnecessary mistakes.
One way to limit your downside risk without sacrificing upside potential is by recognizing what’s called “unsystematic risk.”
This is inside speak that means company-specific risk.
Think of it this way. There is an economy which is driven by all sorts of interconnected factors. Think of the economy as the system. And there is risk inherent in the system. So when we invest in line with a broad market index, we’re taking on the risk of the whole system. This is systematic risk. The whole thing sort of rises and falls together.
Then there’s unsystematic risk. That is the risk that can be attributed to one single company, much less correlated with the rest of the economy. Maybe that company mishandled its finances, made a bad business decision, fell behind the technology curve, or flopped on its latest product or service. Whatever the case may be, the problem is with that company specifically, regardless of what its competitors or other sectors of society experienced.
Let’s start with the good news.
Unsystematic risk is how a very few individuals have become rich virtually overnight. That is, they went all in on a particular company which subsequently grew far and beyond the average stock market, and they multiplied their money several times over in a short amount of time.
But here’s the bad news.
For every story of quick riches with unsystematic risk, there are hundreds more stories of those who lost nearly everything in a bad investment.
Why?
Because unlike systematic risk, the odds are weighted against those who take on unsystematic risk.
The risk of one single company far outweighs the likely reward. That means you’re massively overpaying in terms of risk for the likely outcome that you’ll receive. The difference between unsystematic risk-taking and gambling at the casino is not very wide.
That is why, when it comes to betting heavily on one particular company, it’s best not to allow for more than about 5% of your total investment portfolio to be subject to that risk. Regardless of how confident you are in the investment, the odds are against you. So you always want to seriously consider the question: what if I’m wrong?
That’s not to say you can never take bets. But calculated bets are best in the long-run!
Systematic risk, on the other hand, exhibits a far greater potential for reward for each unit of risk taken on.
In other words, a diversified portfolio will win against the tightly concentrated portfolio in the vast majority of cases.
In a world of uncertainty, betting with the odds is typically the best way to achieve your goals consistently.