Why Systematic Risk Cannot Be Diluted by Diversification

The fundamental principle of risk and return in financial markets is straightforward: investors are willing to undertake a higher risk when they expect a higher return. Financial markets reflect the probability of a variety of investment outcomes that need to be accurately forecasted. As an investor, I regularly seek for favorable investment odds focusing on process versus outcome, playing a game of probabilities and hoping to meet my investment goals. But, what ultimately makes me a successful investor is my degree of awareness of the negative correlation between systematic risk and diversification.

Defining Systematic Risk

Systematic risk is the intrinsic risk of the market. Pervading the economy, systematic risk encompasses interest rates, fiscal policy, monetary policy and market risk including equity risk, currency risk and commodity risk. On a tactical level, market risk is diluted by various risk metrics. On a strategic level, market risk is diversified with the implementation of risk limits.

Some investments are greatly affected by systematic risk that causes sharp fluctuations in the financial markets. To maximize profits I should anticipate any changes in interest rates and/or inflation that possibly affect my purchasing power as well as follow closely the liquidity of the market.

The Importance of Diversification

Today, investors have access to a great variety of investment vehicles. If you are a conservative investor, you seek to preserve your capital by investing in bonds and CDs in exchange for safety and zero risk. If you are moderately aggressive, you typically invest in large and small-cap stocks and mutual funds, seeking for long-term portfolio growth while assuming moderate short-term risk. For every investor profile there are numerous investment options to leverage financial risk.

Portfolio diversification suggests the combination of different investment vehicles that are anticipated to react differently in dissimilar market conditions. If you have low risk tolerance, the relationship between risk and return is primary to your investment decision making. As a risk-averse investor you want to dilute the volatility of your portfolio and you are willing to assume extra risk expecting above-average investment returns. If you are offered two investment options that provide the same return on investment (ROI) but you are required to undertake a higher risk for investment A, you are very likely to choose investment B.

Portfolio diversification can help you achieve portfolio growth while assuming lower risk. A well-diversified portfolio that allocates investment money across uncorrelated securities allows a price decrease in one security to be offset by a price increase in another security. A combination of many securities in a diversified portfolio can lower portfolio risk and maximize returns by capitalizing on diverse market conditions. In this context, portfolio diversification helps you defeating your anxious reaction to fear, while promoting your effort to build wealth.

Why Systematic Risk Cannot Be Diluted

Even a perfectly diversified portfolio that offers exposure to major asset classes including U.S., international and emerging markets large and small cap stocks, corporate and government bonds, ETFs, options, REITs, and cash, cannot dilute systematic risk.

For example, all financial crises since the 1930s include systematic risk:

1) The Great Depression caused a worldwide stock market crash as a result of the Smoot-Hawley Tariff that reduced U.S. exports.

2) The global crash of 1987 that caused the Dow Jones Industrial Average to decline by 22.6% was the result of speculation about the U.S. dollar and inflationary pressures in the U.S. economy.

3) The collapse of Long-Term Capital Market (LTCM) in 1998 was the result of Russia's default on government bonds that led to excessive demand of U.S. Treasury bonds. To satisfy increasing demand, LTCM was forced to liquidate positions and increase interest rates, thus causing turmoil in the U.S credit markets.

In all above financial crises - and in many more since 1930 - financial markets did not collapse because one security declined over another, but rather because investors generally expected or were pessimistic that an economic downturn could greatly affect the market.

To conclude: as an investor, I can manage volatility and correlation among asset classes in my portfolio by carefully selecting securities that can lead to higher returns at a lower risk. But, at the end of the day, managing systematic risk is impossible. Financial markets are not perfect and I cannot know exactly the exposures of the companies I invest in or how and if they are able to hedge their risks by holding well-diversified portfolios.

Sources:

http://www.investopedia.com/terms/s/systematicrisk.asp

http://www.bhpbilliton.com/bbContentRepository/docs/briefingPapers/250BHPRiskMgt.pdf

http://www.allstarstocks.com/0page8.html

http://americanhistory.about.com/od/greatdepression/f/smoot_hawley.htm

http://news.bbc.co.uk/2/hi/business/6958091.stm

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