Idiosyncratic vs. Systematic Risk: A Delicate Balancing Act

Diversifying a portfolio goes beyond asset classes or sectors. Consider idiosyncratic and systematic risk when balancing your portfolio.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Balancing on a tightrope: How to balance a portfolio
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Key Takeaways

  • When diversifying your portfolio, consider both idiosyncratic and systematic risk

  • Weigh the benefits of adding individual stocks to your portfolio versus investing in an index-based product
  • Consider your time horizon, risk tolerance, and any sector preferences when choosing your portfolio mix 

For most major stock indices, 2020 was a good year. But not for all.

For many individual stocks, 2020 was a good year. But not for all.

So, how do you balance out a portfolio to potentially benefit from the gains of broader markets and individual stocks, yet not necessarily go down with the ship if some of those equities or indices tank?

If the answer could be summed up in a single word, it’s diversification.

Risk Duo: Idiosyncratic and Systematic Risk

One approach to diversifying a portfolio is to consider idiosyncratic versus systematic risk. It may sound like a mouthful, but the concepts are pretty straightforward. Idiosyncratic risk refers to inherent risks exclusive to a company. Systematic risk refers to broader trends that could impact the overall market or sector.

An example of idiosyncratic risk would be unexpectedly poor sales of a particular new version of the iPhone. That risk would be specific to Apple (AAPL).

Systematic risk would be if the Federal Reserve unexpectedly raised interest rates, in which case all the major stock indices could potentially take a dive. That’s a fundamental factor that might cause the broader markets to fluctuate.

Arguably, every stock or stock index has both idiosyncratic and systematic risk. How do you balance that?

Playing the Diversification Game

“When building a portfolio, if you have amassed a large amount of one stock, your portfolio’s day-to-day fluctuations are based on that one business, less so the market, so you are not diversified,” said Viraj Desai, senior manager, portfolio construction at TD Ameritrade.

Transversely, if your portfolio is invested based on broad indices, you could miss out on any gains of individual stocks that beat the index.

“It’s about a spectrum. For long-term exposure, it’s better to have more systematic risk. But if you’re looking to add value, you want to add idiosyncratic risk by being overweight in a stock in the index that you think will outperform it,” Desai explained. “When you think about portfolio drivers, you want to have a proper mix. If you own securities based on several broad market indices, you may be diversified, but if you own a handful of stocks in each index, you can potentially add value beyond what the index is providing, if you are correct.”

Real-World Examples of Diversification

Let’s look at some examples. Last year, the S&P 500 Index (SPX) and Nasdaq (COMP) were up 16% and 43%, respectively. Not bad. But if you had owned some individual stocks, you could’ve done even better. Just look at electric car maker Tesla (TSLA), up 743%; semiconductor firm Nvidia (NVDA), up 122%; or data processing service PayPal (PYPL), which was up 117%. Sure, this is in hindsight, but the point is that if those (or many other stocks that outperformed the index) were included in a portfolio, the returns would’ve been amplified.

Don’t forget that the idea of balancing a portfolio is not just important when the market is going up. During the financial crisis of 2007–08, Bank of America (BAC) went down about 90%. For that same period, the SPX went down about 40%. Although that loss in index value still hurt, it would’ve been worse if you had only BAC in your portfolio.

It’s OK to broadly diversify a portfolio based on indices by layering in your own convictions. But keep in mind that a little bit can go a long way. If you’re right, you beat the index. If you’re wrong, you don’t lose as much and are still on track.

What’s in Your Portfolio?

Many individual investors may own 20 to 40 individual stocks. That’s fine, but as more stocks are added, the benefits of idiosyncratic risk could be diluted. “You might be better off going down the list of stocks to see if it might be better owning an index-based product,” Desai said.

There are other considerations. For one, what are your convictions? Do you feel strongly about a particular stock or sector? Then you might want to act on your beliefs and be overweight in a stock you favor. Are you a passive or active investor? If you’re passive or in the markets for the long term, such as building your retirement nest egg, indices might be a sufficient route to take. If you’re active, which takes time to research, then you might consider adding more individual listings.

Take that portfolio of 20 to 40 stocks just discussed, and say 10 of those stocks are in the Technology sector. An alternative might be to add a tech index and keep only two or three of those individual tech stocks you think have the best chance of outperforming the tech index.

If this still seems overwhelming, Desai suggested looking at a broad market index like the SPX, considered by some the gold standard for systematic risk exposure. If you’re a more active investor who looks at the short term, consider examining one or two individual stocks out of the 500 listings in the index.

Of course, picking stocks that are likely to outperform the index is easier said than done. Deploying risk management strategies like these are considered common practices to better benefit from the upside, and if you’re wrong, they could potentially decrease the negative impact of the downside.

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Key Takeaways

  • When diversifying your portfolio, consider both idiosyncratic and systematic risk

  • Weigh the benefits of adding individual stocks to your portfolio versus investing in an index-based product
  • Consider your time horizon, risk tolerance, and any sector preferences when choosing your portfolio mix 

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