Idiosyncratic vs. Systematic Risk: A Delicate Balancing Act

After an eventful investing year—especially one like 2022 that sent most major indexes into bear territory—reviewing basic principles of investment risk is probably worthwhile.

Start with a question: How do you balance out a portfolio to help mitigate risks in different market conditions? 

If the answer could be summed up in a single word, it’s diversification, or in this case, portfolio diversification, which requires an understanding of two kinds of risk that can help investors make potentially safer decisions. 

The dynamic risk duo: Idiosyncratic and systematic risk

One approach to diversifying a portfolio is to consider idiosyncratic versus systematic risk. For such elevated terminology, 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 is unexpectedly poor sales of a particular new version of a mobile phone or laptop. That’s a form of risk that could be faced by a company like Apple (AAPL), a leader in such products.

An example of systematic risk is the Federal Reserve steeply raising interest rates in an inflationary environment—hello again, 2022. Central banks raise rates to slow demand and increase prices, which can sink an economy; however, such actions can also destabilize global investment markets.

Arguably, every stock or stock index has both idiosyncratic and systematic risk. So, how do you balance the two?

Playing the diversification game

When building a portfolio, if you’ve amassed a large amount of one stock, your portfolio’s day-to-day fluctuations are based on that one business and less so on the market. That means you may not be as diversified as you need to be.  

On the other hand, if your portfolio is invested only in broad indexes, you could miss out on any gains of individual stocks that beat the index.

Diversification means investing along a spectrum based on your particular investment goals and timeline. Generally, for long-term exposure, it’s better to have more systematic risk. But if you’re looking to add value, you can choose to add idiosyncratic risk by being overweight in a stock in a particular index that you think will outperform it.

In short, when you think about portfolio drivers, you want to have a proper mix. If you own securities based on several broad market indexes, 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’re correct. 

Real-world examples of diversification

Turn the clock back to 2020, when the Nasdaq® ($COMP) was up 43%. Those who had owned some individual stocks in that index could’ve done even better—take electric car maker Tesla (TSLA), up 743%, and semiconductor firm Nvidia (NVDA), up 122%.

Turning to year-end 2022, rising rates—again, systemic risk—created a historically bad environment for growth companies that typically need to borrow to expand. During the early months of the pandemic, interest rates were near zero. As inflation accelerated over last year, many growth stocks like those above lost significant ground in 2022 as they shouldered higher borrowing costs amid slowing sales. 

By December 30, 2022, $COMP finished down 20%, but TSLA had lost nearly 65% and NVDA gave up nearly 50% of its value. So, don’t forget the idea of balancing a portfolio is not just important when the market is going up.

It may be suitable to broadly diversify a portfolio based on indexes by layering in your own convictions. But keep in mind, a little bit can go a long way. However, diversification does not eliminate the risk of experiencing investment losses. If you’re right, you can potentially beat the index. If you’re wrong, though, the idea behind a diversified portfolio is to potentially help mitigate your losses, but there is no guarantee. 

What’s in your portfolio?

Many individual investors may own 20 to 40 individual stocks. That’s fine, but as they add more stocks, the benefits of idiosyncratic risk could be diluted. Sometimes, it can be helpful to go down the list of stocks to see if it might be better to own an index-based product.

There are other considerations. For one, what are your convictions? Do you feel strongly about a particular stock or sector? After performing due diligence, some investors may choose to act on their beliefs and be overweight in a stock they favor. Are you a passive or active investor? For some passive or long-term investors with goals like building a retirement nest egg indexes might be a sufficient route to take. Some active investors may find adding more individual listings more suitable, but doing the research takes time.

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, consider looking at a broad market index like the S&P 500® index (SPX), which some investors deem the gold standard for systematic risk exposure. If you’re a more active investor who looks at the short term, think about examining one or two individual stocks out of the index’s 500 listings.

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 help benefit from the upside and attempt to decrease the negative impact of the downside.