Be Aware of Systematic Risk
It is all well and good to assess an investment's potential return. The problem is, however, many investors neglect to assess the risk aspect of their investments. It is important investors be aware of Systematic Risk and Unsystematic Risk otherwise they may get a ‘rude awakening’.
In this first of a two-part post, I touch upon why investors should understand Systematic Risk; this is the risk inherent to the entire market.
A follow-up post will address Unsystematic Risk, also known as Market Risk or Diversifiable Risk. Diversification reduces the risk that is unique to a single security, business, industry, or country. Investors, however, are still subject to market-wide systematic risk.
Companies face similar risks. They just come in varying degrees of severity. Investors must be aware of the systematic risk to be adequately compensated for the investment risk.
Systematic Risk (Market Risk, Undiversifiable Risk)
Systematic risk is unpredictable and impossible to entirely avoid. This is where the risk of the overall security in the marketplace is affected by changes in the economy.
Diversification does not mitigate this risk. It is mitigated through hedging or a proper asset allocation strategy.
Inflation affects an investment portfolio. Theoretically, a company’s revenues and profits should grow at least at the same rate as inflation. Studies have found, however, that rising inflation results in higher input prices and a reduction in consumer purchasing power thus resulting in a decline in company revenues and profits. The economy slows for a period until a measure of economic equilibrium is reached.
Inflation impacts value stocks differently from growth stocks. Value stocks generally perform better in high inflation periods and growth stocks perform better during low inflation periods. Stocks overall do seem to be more volatile during highly inflationary periods.
Reinvestment risk is the chance an investor will have to reinvest money from an investment at a rate lower than its current rate. This risk is most commonly found with bond investing. It can, however, apply to any cash-generating investment.
One way to partially mitigating reinvestment risk is to create a bond ladder. This is a portfolio holding bonds with widely varying maturity dates. Since the market is cyclical, high-interest rates fall too low and then rise again. A properly structured bond ladder has some bonds mature in a low-interest-rate environment. These are then offset by other bonds that mature when interest rates are high.
Although I invest solely in equities I nevertheless, experience reinvestment risk. This is because receipt of dividends is totally independent of how a company’s stock price is performing.
Over the years I have automatically reinvested most of our dividend income. I decided to follow this course of action to reduce the extent to which my emotions might affect wealth creation. Furthermore, our investments are diversified over 19 accounts. It has been far easier for me to have everything on ‘autopilot’.
Interest Rate Risk
Historically, rising interest rates have harmed stock prices and investments.
Rising interest rates negatively impact debt-laden companies or companies that need to take on more debt. If a company’s higher borrowing costs reduce profitability and ability to grow, then earnings decline and the stock may very well become less desirable thus resulting in a share price decline.
We must also consider the impact rising interest rates have on a company’s customer base. The financial health of customers directly affects a company’s ability to grow revenue and profitability. Increased interest rates negatively impact customers which directly impacts a company’s ability to grow.
Rising interest rates also cause investors to rethink their investment strategies since interest rate changes impact some industries to a greater degree than others.
We also have to consider that high or rising interest rates can negatively impact an investor’s total financial picture. An investor struggling with burdensome debt might liquidate equities to raise funds to repay the high-interest debt; selling equities to service debt is a common practice. When taken collectively, stock prices can be negatively impacted.
Currency risk is the risk of a change in the value between currencies. The risk is very real but many investors overlook it. While the value of your investments may rise, the value of your investments when converted to your base currency could wipe out your stock gains. Alternatively, you may have the good fortune of the FX rates working in your favour.
I retain all my equity trade confirmations. I executed several purchases in the January 2010 – December 2013 timeframe. These purchases were fortuitous in that our CDN dollar was almost at par with the US dollar. As luck would have it, the value of the underlying securities has subsequently appreciated and the CDN dollar has weakened relative to the USD.
In contrast, many CDN investors converted CDN to USD to purchase US-listed shares between August 1998 and February 2003. One quick look at the USDCAD conversion graph shows that any appreciation in a company’s share value for purchases made during this timeframe would have been negatively impacted by the subsequent strengthening of the CDN dollar.
Both discount trading platforms I use are those of my former employers. I needed to obtain pre-approval of all my trades as part of the terms and conditions of my employment with my last employer. I had no objection to this.
My objection was the conversion of US dividends within tax-advantaged accounts to CDN. Since all dividends were being automatically reinvested, the CDN was converted back to USD to acquire new shares.
I raised my objections on a few occasions. After I retired in May 2016, the trading platform was upgraded to the 21st century around August 2018!
I have no idea if the same buy/sell rate was being used. It did, however, irk me that I faced foreign exchange risk because of the platform’s shortcomings.
The very nature of investing means there is an element of risk. It is important investors be aware of Systematic Risk even though it is unpredictable and impossible to entirely avoid. Being aware of Systematic Risk helps us plan to mitigate this risk through hedging or by using a proper asset allocation strategy. Diversification will not help mitigate this risk.
I invest solely in common shares of high-quality companies so I am NOT a good example of how to mitigate Systematic Risk. This, however, is perfectly fine with me. Share prices can drop and stay low for a protracted period of time and I am fine with this. Quite frankly, I would welcome this because we could acquire shares in high-quality companies at better than current valuations.
We expect a significant tax issue if we leave our Registered Retirement Savings Plans (RRSPs) in place for another decade at which time they must be converted to RRIFs. This year, we will commence our RRSP ‘meltdown strategy’. The speed at which we 'meltdown' our RRSPs, however, is very flexible. We have a decade over which to do this so we can time the sale of our RRSP investments for withdrawal purposes. Also, I recently terminated the automatic dividend reinvestment arrangements within our RRSPs. Cash is now accumulating in these plans. This will permit us to withdraw funds without being forced to sell securities.
Unsystematic Risk can be reduced through diversification. I address this in my next article.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.