Unsystematic Risk is Not Relevant: Why You're Worrying About the Wrong Thing
Why? Because in a well-diversified portfolio, unsystematic risk is negligible. It’s akin to focusing on a small leak in a boat when the ocean is calm and vast. Systematic risk, on the other hand, is the storm. The crash of 2008? That’s systematic risk. The tech bubble? That’s systematic risk. Unsystematic risk, by contrast, is the noise—individual company mishaps, internal mismanagement, or one-off events. These are drops in the ocean, which can easily be smoothed out with proper diversification.
Here’s the hook: Diversification is the ultimate key. But let me clarify—diversification isn’t about owning 20 different stocks from the same sector or putting all your savings into one asset class. It’s about global, cross-sector, and multi-asset-class diversification that neutralizes unsystematic risk.
Take a moment to reflect on your own portfolio. If you're constantly adjusting it for the sake of avoiding individual stock failures or reading news about companies collapsing and feeling the need to act, you're probably reacting to unsystematic risk. That’s the distraction. The real game is handling systematic risks that affect entire markets, not individual entities.
Unsystematic risk, simply put, can be diversified away. This is why it’s not relevant to focus too much on it. While systematic risks are unavoidable and need to be managed actively, unsystematic risks become irrelevant in a well-balanced portfolio.
Let’s break it down:
| Type of Risk | What It Affects | Example | Mitigation |
|---|---|---|---|
| Systematic Risk | Entire market or economy | 2008 Financial Crisis | Hedging, global diversification |
| Unsystematic Risk | Specific to a company or industry | Enron collapse | Diversification across sectors |
Most of us spend way too much energy trying to avoid unsystematic risks. But when you think like a seasoned investor, it’s clear: you cannot diversify away from systematic risks, such as a recession or a market-wide correction. However, if you’ve built a portfolio across industries, geographies, and asset classes, unsystematic risks will hardly register a blip on your radar.
Now, consider this: how much of your mental bandwidth have you dedicated to worrying about things like bad management in one company, lawsuits in another, or product failures in yet another? These are real, but diversifiable. So why waste your time?
The Capital Asset Pricing Model (CAPM) introduced us to the concept that investors should only be compensated for bearing systematic risks because unsystematic risks can be eliminated through diversification. This is why professional investors place far more emphasis on broad market trends, macroeconomic data, and geopolitical issues than on individual companies’ quarterly earnings reports.
Unsystematic risks, like a company’s earnings miss, product failure, or management changes, will always exist, but they become irrelevant in a properly diversified portfolio. By owning a large enough collection of assets that behave differently under different conditions, you smooth out the bumps.
The bottom line: stop worrying about the individual trees and start focusing on the forest.
The problem arises when investors misunderstand the nature of the risks they are exposed to. Unsystematic risk is the type of risk you can diversify away. By owning stocks in different industries, geographies, and asset classes, you're effectively protecting yourself from a catastrophic failure of any single stock or sector.
Imagine you own only stocks from a single technology company. What happens when that company faces a downturn or regulatory issues? You’re heavily exposed to unsystematic risk. Now imagine you own stocks across different sectors—say technology, healthcare, energy, and consumer goods—alongside bonds, real estate, and international assets. Now, any single company’s failure is just a small dent in your overall wealth.
So, what's next?
Look at your investments. Are you over-indexed on individual stocks or sectors? Are you diversifying beyond just owning multiple stocks? The modern portfolio should be dynamic and spread across various asset classes that behave differently under different market conditions. By doing so, you effectively reduce unsystematic risk to irrelevance.
Next time you catch yourself worrying about a company’s latest earnings report, remember: the noise doesn't matter. What matters is how you're positioned to weather the broader economic storms—because those are the risks you can’t diversify away from.
Want a more concrete example? Let’s consider Warren Buffett’s investment strategy. Buffett famously holds concentrated positions in individual companies, but his overall portfolio reflects diverse economic sectors. The lesson here is that he’s not betting on single company survival—he’s betting on broad, diversified, long-term value creation across industries.
Even for the most diligent stock pickers, like Buffett, unsystematic risk is managed through smart diversification. It's why Berkshire Hathaway owns businesses across insurance, railroads, utilities, and manufacturing.
This is where the magic of diversification kicks in. Imagine a football team where every player is a star forward. It doesn’t matter how talented they are—without defenders, they’ll lose. Similarly, a portfolio too heavily weighted towards a single sector or asset class is vulnerable. You might win some games, but when the defense fails (think economic downturns), you’ll lose big.
The question to ask yourself isn’t whether you’ve done enough research on a company. It’s whether your portfolio is designed to protect against the risks you cannot control while minimizing the risks you can control.
Key takeaway: stop sweating the small stuff. Unsystematic risk is noise—meaningless, background chatter. In the grand scheme of things, it won’t break your portfolio if you’ve diversified correctly. Focus on the bigger picture. Invest in a well-rounded portfolio that accounts for different sectors and markets, and ensure you're prepared for the systematic risks that no one can avoid.
By now, you should feel a bit lighter. You can stop the constant worry over the micro-failures of companies in your portfolio and start playing the long game, focusing on reducing systematic risk through diversification. The future of investing isn’t about avoiding unsystematic hiccups but about bracing for the larger, inevitable waves of the market.
Top Comments
No Comments Yet