One way academic researchers measure investment risk is by looking at stock price volatility. Two risks associated with stocks are systematic risk and unsystematic risk. Systematic risk, also known as market risk, cannot be reduced by diversification within the stock market. Sources of systematic risk include: inflation, interest rates, war, recessions, currency changes, market crashes and downturns plus recessions. Because the stock market is unpredictable, systematic risk always exists.
Systematic risk is largely due to changes in macroeconomics. Reducing systematic risk can lower portfolio risk; using asset classes whose returns are not highly correlated (e.g., quality bonds, stocks, fixed-rate annuities, etc.). It is possible to have higher risk-adjusted returns without having to accept additional risk, a process called portfolio optimization.
The website InvestingAnswers.com describes systematic risk as being “comprised of the unknown unknowns occurring as the result of everyday life. It can only be avoided by staying away from all risky investments…because of market efficiency, you will not be compensated for additional risks arising from failure to diversify your portfolio.” Reducing a portfolio’s systematic risk is accomplished by reducing stock exposure or by including other asset categories, such as commodities, quality bonds, CDs, or fixed-rate annuities.
Unsystematic risk, also known as company-specific risk, specific risk, diversifiable risk, idiosyncratic risk, and residual risk, represents risks of a specific corporation, such as management, sales, market share, product recalls, labor disputes, and name recognition. This type of risk is peculiar to an asset, a risk that can be eliminated by diversification.
The portfolio’s risk (systematic + unsystematic) is measured by standard deviation, variation of the mean (average, not annualized) return of a portfolio’s returns. Table xx shows how quickly unsystematic risk is reduced when a modest number of stocks are added to a single-stock portfolio. The table comes from an October 1977 article by E.J. Elton and M. J. Gruber published in the Journal of Business. Most unsystematic risk is eliminated if the portfolio is comprised of 20+ stocks from several different sectors.
Phrased another way, 61% of stock risk can be eliminated by owning 200+ stocks (or a single, broad-based U.S. stock index fund); 56% risk reduction with just 20 stocks from several sectors. The total risk for a well-diversified stock portfolio is basically equivalent to systematic risk. While an investor expects to be rewarded for bearing risk, one is not rewarded for taking on unnecessary risk, such as unsystematic risk.
BusinessDictionary.com notes systematic risk “cannot be circumvented or eliminated by portfolio diversification but may be reduced by hedging. In stock markets systemic risk (market risk) is measured by beta.” Owning different securities or owning stocks in different sectors can reduce systematic risk.
Table 1
Stock Portfolio: Standard Deviations of Annual Returns
[how risk is reduced when stocks from different industries are added]
Number of Stocks | Standard Deviation | Risk Reduced | Number of Stocks | Standard Deviation | Risk Reduced | |
1 | 49.2% | 0% | 30 | 20.9% | 58% | |
2 | 37.4% | 24% | 50 | 20.2% | 59% | |
4 | 29.7% | 40% | 100 | 19.7% | 60% | |
6 | 26.6% | 46% | 200 | 19.4% | 61% | |
8 | 25.0% | 49% | 500 | 19.3% | 61% | |
10 | 23.9% | 51% | 1,000 | 19.2% | 61% | |
20 | 21.7% | 56% |
A classic 1968 study by Evans and Archer, Diversification and the Reduction of Dispersion, concluded an investor owning 15 randomly chosen stocks would have a portfolio no more risky than the overall stock market. This research confirmed earlier advice from Benjamin Graham in his 1949 book, The Intelligent Investor. Graham recommended owning 10-30 stocks for proper diversification.
