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Reduce Unsystematic Risk Through Proper Diversification
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 reduce Unsystematic Risk through proper diversification otherwise they may get a ‘rude awakening’.
In my Be Aware of Systematic Risk article, I touch upon why investors should understand Systematic Risk; this is the risk inherent to the entire market.
In this follow-up post, I address Unsystematic Risk. Market Risk or Diversifiable Risk are common terms used. This risk is unique to a single security, business, industry, or country. It is reduced through diversification but investors are still subject to market-wide systematic risk.
The following is a list of Unsystematic Risks investors must consider.
Strategic Risks
Strategic risks affect or are created by an organization’s business strategy and strategic objectives.
Risk is uncertainty. A company, however, has to take risks to reach goals. This is exceptionally true during changing times.
Strategic risk is the negative impact of risk and also the sub-optimization of gain. Companies must figure out the value protection and value creation aspects of risk that set up the company for success.
Reputation Risks
Reputation is rated a 'highest impact risk area'. It was a top risk area in the financial industry in which I was employed long before it became a top risk in other industries.
This form of risk has now vaulted to one of the top risks in the energy sector in part to headlines about fracking, oil spills, and the Alberta tar sands.
A similar rise in reputation risk has occurred in life sciences and health care. This has likely been driven by US health care reform efforts and ongoing concerns about the skyrocketing cost of pharmaceuticals and health services.
I think back to some of the activities that were common when I started my banking career in Calgary in the early 1980s. One particular event every late February was ‘Bosses’ Night’. Staff members only. No ‘significant other’. I need say no more.
Financial Risks
These risks include financial reporting, valuation, market, liquidity, and credit risks. Financial risk is not inherently good or bad. It only exists to different degrees.
This risk generally relates to the odds of losing money. The possibility that a company's cash flow will prove inadequate to meet its obligations is perhaps the most common example of a company’s financial risk.
Risk by its very nature has a negative connotation, and financial risk is no exception. Risk can spread from one business to an entire sector, market, or even the world. Furthermore, it can stem from uncontrollable outside sources or forces which are often difficult to overcome.
Investors must assess the degree of financial risk associated with a security or asset to determine an investment's value. We make better and more informed investment decisions when we understand the possibility of financial risk.
We use fundamental, technical, and quantitative analysis to analyze risks associated with long-term investments. Some very basic ratios we use to assess a company’s financial risks are:
- Working Capital Ratio;
- Quick Ratio;
- Earnings per Share (EPS);
- Price-Earnings (P/E) Ratio;
- Debt-Equity Ratio;
- Return on Equity (ROE)
Compliance Risks
These risks relate to legal and regulatory compliance. Companies are exposed to legal penalties, financial forfeiture and material loss when they fail to act under industry laws and regulations, internal policies or prescribed best practices.
This was perhaps one of the fastest-growing areas within the bank with which I was employed before retirement!
Compliance risks include:
- Workplace Health and Safety
- Employee Behavior
- Corruption
- Data Management
- Environmental Impact
- Social Responsibility
- Process
- Quality
Business Risk
Business risk refers to a threat to the company’s ability to achieve its financial goals. These risks are not always attributed to a company’s leadership.
The primary 3 causes are:
- Natural - floods, earthquakes, cyclones, and other natural disasters;
- Human - negligence at work, strikes, work stoppages, and mismanagement;
- Economic - rising prices of raw materials or labour costs, rising interest rates on debt, and competition.
Operational Risks
These major risks affect an organization’s ability to execute its strategic plan. Operational risk falls into the category of business risk. Operational risk mitigation is focused on risk reduction within an organization versus what is produced or inherent within an industry.
These risks are often associated with active decisions that relate to how the organization functions and its priorities. The risks might not result in failure, lower production, or higher overall costs. They are, however, seen as lower or higher risks depending on various internal management decisions.
This risk reflects man-made procedures and thinking processes. Operational risk, therefore, is the risk of business operations failing due to human error so industries with lower human interaction are likely to have lower operational risk.
This type of risk differs between industries and is an important consideration when looking at potential investment opportunities.
Default Risk
This risk goes beyond a lender and borrower relationship. Any company which extends payment terms to its customers faces this type of risk. When an investor is exposed to a higher risk of default risk, a higher rate of return is required to compensate for increased default risk.
In my recent Invest By Assessing the 5 Cs of Credit, I provided links to the websites of the major rating companies (Moody’s, S&P Global, and Fitch).
Periodically check the ratings of the companies in which you invest and the ratings of the companies in which you are thinking of investing. Check when the debt was last rated and if the ratings have recently been affirmed or if they are under review for possible downgrade/upgrade. It is also important to cross-reference the assigned ratings to the credit rating codes and classes and the rating tier definitions.
Political Risk
Political risk is the risk an investment's returns could suffer as a result of political changes or instability in a country. A change in government, legislative bodies, other foreign policy makers, or military control can increase instability which then has an impact on potential investment returns.
Canada and the US have a low political risk while foreign investments often have a higher political risk. Some examples of political risk include trade barriers, taxes, legislation, and administration.
Marsh McLennan, a leader in risk, strategy and people, has produced an interesting Political Risk Map for 2020.
Investment Manager Risk
Investment manager risk is a broad term that encompasses essentially all losses arising from the mistakes, negligence, and incompetency of the managers in charge of a financial portfolio. It can also refer to changes in the investment style or a change in the management team.
Risks other than unforeseeable risk factors, political interventions, and broad economic crisis fall under the heading of investment manager risk.
Self Directed Financial Management Risk
A very simplistic example is when one family member manages the household’s investments and a sudden and unexpected event results in this family member no longer being capable to continue this activity. The degree of urgency might be far greater when this family member manages complex or speculative investments and cash flow is generally tight.
Liquidity Risk
Liquidity risk occurs when an individual investor, business, or financial institution cannot meet its short-term debt obligations. The investor or entity might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market.
Investors should use liquidity measurement ratios when evaluating a company. Commonly used liquidity ratios include the current ratio (current assets/current liabilities) and the Quick ratio (Current assets minus inventory/current liabilities).
When a company has too much liquidity risk, it must sell its assets, bring in additional revenue, or find other means in which to reduce the gap between available cash and short-term obligations.
Liquidity risk also pertains to the ability to sell an investment quickly at a competitive price. Marketability risk is the ability to find a ready market where the investor can sell the investment.
Real estate, for example, is marketable but is usually not liquid. Preferable forms of immediate liquidity include Cash, T-Bills, GICs, highly traded marketable securities.
Typically, a less liquid or less marketable asset will exhibit more risk.
Tax Risk
Companies face the challenge of complying with ever-changing and evolving tax rules and guidelines. The passage of the 2017 Tax Cuts and Jobs Act (TCJA), for example, added further uncertainty to the already risky environment.
The following 7 areas are especially prone to errors.
- Deferred tax assets and liabilities;
- Valuation allowance;
- Purchase price adjustments and detail related to business combinations;
- Foreign currency translation;
- Uncertain tax position;
- Accounting method changes;
- Transfer pricing.
Final Thoughts
Investors must reduce Unsystematic Risk through proper diversification when making investment decisions.
If you are reluctant to invest because of the risks presented then be aware you trigger risk. You trigger erosion of wealth if you exclusively invest in extremely safe investments where the rates of return are lower than the rate of inflation.
Be aware of Unsystematic Risk. Every investment consists of risk/reward. Risk is a natural element of investing. Identify the risks and learn to manage them. You will find the risk of financial stress diminishes when you reduce Unsystematic Risk through proper diversification.
I wish you much success on your journey to financial freedom.
Thanks for reading!
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.
