Nonsystematic and Systematic Risk

On 05/18/2010, in Investment Concepts, by Jordan Wilson

When making investment decisions, one should always perform both quantitative and qualitative analysis.

By investment decisions, I include financial instruments such as stocks and bonds. But it also refers to any decisions you make when operating a business.

Do I buy or rent my office space or production equipment? Do I develop and market a new product? Do I move into a new geographic region? These are also investment decisions.

Quantitative Analysis

Quantitative analysis is number crunching.

Think of it as quantitative equals quantity.

You take raw data, perform specific calculations, and arrive at a hard number.

Quantitative analysis attempts to be objective. That is, for a given set of data, different individuals should arrive at the same conclusion.

With investment risk, calculating the standard deviation is an example of quantitative analysis.

Some people fall in love with quantitative analysis. It is reassuring to get objective results that can be directly compared against multiple investment options.

Plus it is nice to be able to “blame the numbers” when you make the wrong decisions.

For example, two possible investments both have 10% expected returns. You perform the proper calculations and find that investment A has a standard deviation of 5%, while investment B has one of 8%. You “know” that investment A is the less risky option.

While I agree that quantitative analysis is important, I am leery of relying solely on it.

As we saw previously, there are limitations to the use of standard deviations. The same is true for most quantitative analysis.

Often, historic data is a key input for quantitative analysis. Yet past results are no guarantee of future performance.

Also, when modelling future results, variable inputs (e.g. inflation, growth rates, etc.) must be determined. Often these require best guesses of the future. Even the best of guesses may not be accurate.

While quantitative analysis is very useful, it should never be used as the only means of decision-making.

You also need to deal with qualitative aspects to get the whole picture.

Qualitative Analysis

Qualitative analysis is more “touchy-feely” than quantitative analysis.

Whereas quantitative analysis tries to be objective, qualitative analysis is subjective.

Think of it as qualitative equals qualities of the investment.

There are no hard numbers that you can calculate in order to arrive at your decisions. The information is there, one just needs to know how to find it. Usually experience and intuition are key factors in arriving at the correct results.

What one person may discern may be completely different than another might find.

In the realm of qualitative analysis are the two major components of investment risk. Although they are called a variety of names, we will use the terms nonsystematic and systematic risk.

Each investment decision has components of both nonsystematic and systematic risk. If you can learn to identify the key subsets of these two risk components, you will have an advantage over others when making decisions.

Today we will briefly describe both components. In subsequent posts, I shall identify some of the more common subsets of each class and ways to deal with them.

Nonsystematic Risk

Nonsystematic risks are unique to a specific company, industry, asset, or investment.

Note that when I use the term “company”, for ease in writing, I shall also include sole proprietorships, partnerships, joint ventures, etc. under this heading. If there are any differences worth noting, I shall split them out at that point in time.

Nonsystematic risks may also be called specific, non-market, security-related, idiosyncratic, residual, unique, unsystematic, or diversifiable risk.

Systematic Risk

Systematic risk is derived from risks that effect the entire market or a specific segment of the market. Systematic risk factors are far reaching and impact all companies or other investments to some extent.

These factors are not unique to the investment under consideration. They will impact a company regardless of how the company operated or manages its risks.

Systematic risk may also be called non-diversifiable, non-controllable, or market risk.

Dealing With Nonsystematic and Systematic Risk

For passive investors (i.e. investors of financial instruments), minimizing nonsystematic risk factors is not difficult. By adequately diversifying your investment portfolio, you can effectively manage nonsystematic risks.

Some academics believe that by holding between 12 and 18 stocks (or bonds), one can achieve adequate diversification to eliminate nonsystematic risk. Yes, but they need to be the correct mix of assets. When we discuss portfolio creation later on, I will consider how to properly diversify an investment portfolio.

For those managing a business, it is impossible to diversify one company. However, by being able to identify the nonsystematic risks, you can take steps to reduce their potential impact. We will look at the specific risks and how to deal with them in my next post.

As some of the alternate names suggest, systematic risk is more difficult to manage. Although sometimes called non-diversifiable or non-controllable risk, you can actual take measures to reduce this risk. Diversification, insurance, and hedging are examples of ways to address systematic risk. When we look at portfolio construction, I will make suggestions on dealing with systematic risk issues.

Next up, a deeper examination of nonsystematic risk.

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