Academic theory recognizes two types of investment risk. Understanding both types of risk, and the difference between them, can help make you a better investor. There is also a money-making opportunity here. Let’s take a look.
The two risk types are idiosyncratic risk and systematic risk. One exists at the level of individual companies or stock investments. The other exists at the level of the broad market.
Idiosyncratic risk covers stuff that happens to an individual company. Take Tesla for example (Nasdaq: TSLA).
The fortunes of Tesla are very much tied to the company’s high-profile CEO, Elon Musk. This can be good or bad, depending on what happens. Musk can take actions that make the Tesla share price go higher — or he can take actions that make it go lower, depending on what happens.
The point is that the behavior of a CEO, and particularly a famous one like Musk, has an impact at the individual company level.
The same applies to management decisions like whether to issue more shares, start a new product line, or pay down debt.
These factors and others produce idiosyncratic risk, which can be good or bad depending on what the share price does. Whatever impacts the share price in this “bottom up” type of way qualifies as idiosyncratic, where the risks for each investment are different (and can sometimes vary wildly).
Systematic risk applies to the entire “system,” meaning the entire financial system or the broad market as a whole. Systematic risk covers inputs that can impact the entire stock market at once, or drive movements across an index like the S&P 500 or Russell 2000.
Two examples of systematic risk are interest rates and economic health. Interest rate changes — or Federal Reserve commentary on the direction of future interest rate changes — can shift the outlook for the entire market, causing investors to become aggressively bullish or bearish (or anywhere in between).
The health of the economy is also closely monitored. Investor sentiment can swing wildly, from optimistic to pessimistic or vice versa, based on the latest jobs number or GDP estimate.
There are different ways to handle idiosyncratic risk and systematic risk. For example, idiosyncratic risk can be reduced through diversification and position sizing.
If your portfolio is divided up among 20 different stocks, for example, you will have far less idiosyncratic risk exposure than someone whose portfolio is invested in just two stocks.
If something goes wrong at the company level in a 20-stock portfolio, the position will likely be small enough to keep the damage contained. (If something goes wrong in a two-stock portfolio, in contrast, that could really hurt.)
To help manage idiosyncratic risk, TradeStops offers tools like the Stock State Indicator (SSI), the Volatility Quotient (VQ), and trailing stop alerts. These tools and others can be used to track and manage individual stock positions, thus keeping a handle on idiosyncratic risk.
Systematic risk is harder to manage because it impacts the whole market. For example: If most of the stocks in the S&P 500 and Russell 2000 move together on a major news development, there is no simple way to diversify against that. What’s more, some systematic risk factors can apply not just to U.S. equities, but to the entire global financial system.
But systematic risk in a portfolio can sometimes be reduced by holding different types of assets, or by adding bearish positions as a hedge against bullish ones as we discussed last month.
This can work because not all assets move the same way, and some assets tend to rise in price even as stocks go sideways or decline. If parts of a portfolio can zig when the rest of the portfolio zags, systematic risk is lowered.
Gold and Bitcoin, for example, have a positive correlation to inflation fears and geopolitical worries, whereas equity prices in general are hurt by those things.
That is partly why we saw gold and Bitcoin surge in recent months, even as stocks struggled with the threat of a U.S.-China trade war and escalating tensions with Iran. This is also why, if we see a rising threat of recession and new monetary stimulus from central banks, gold and Bitcoin could continue to rise sharply even as stocks go sideways or fall.
Another example of hedging against systematic risk — a way to reduce it in a portfolio — is to invest a portion of the portfolio in “recession stocks.” These are industries and companies that not only fare well in a downturn, they fare best of all in the midst of a recession — even as most other companies struggle.
Debt collection companies fit this bill, thanks to the natural correlation between economic downturns and a rise in bad debts. For debt collectors, more bad debt means higher levels of revenue and profit. Thrift stores can also do well in downturns, as U.S. consumers pinch pennies and focus on reduced spending.
You can easily identify companies that are attractive to own in a downturn — providing a hedge against systematic risk — via our groundbreaking software tool, Ideas by TradeSmith. By using our algorithms to identify rising trends, you can uncover stock market winners in real time, even if the rest of the market is stalling or falling. You can achieve similar results by scanning the stock holdings in our Billionaire’s Club roster of investment legends.
In either case, TradeSmith can give you the tools to handle both idiosyncratic risk and systematic risk — and possibly become a more profitable investor as a result.
Richard Smith, Ph.D.
CEO & Founder, TradeSmith