Understanding Risk & Volatility Part 2

Systematic vs. unsystematic risk

Systematic risk refers to the volatility of the general market. Stock prices fluctuate day to day because of news or events that are occurring.  If bad news comes out about the government, for example, the entire stock market could be down. While some stocks may be down more than others the market as the whole suffers.

An investor cannot get rid of or “diversify” away from this risk with other securities. One is exposed to the risk because they participate in the stock market. To help minimize the risk, an investor could also participate in another type of market at the same time; the other market would have to move out of sync with stocks. The “other” market would then be impacted by other factors in the environment when compared to stocks.

Using investment analysis, we measure how a stock, or security, will move with the market and we call that beta. A beta of 1 means the security moves in line with the market. A beta of greater than 1 indicates the security is more volatile or has larger swings in price than the market. A beta of less than one means that the security is less volatile than the market.   The market is usually represented by a broad market index like the S&P 500 as an example. You can find information on beta using Yahoo Finance.  Here is a snapshot of Apple, Inc. stock on Yahoo.

The beta of the AAPL stock is currently 1.08 (on March 9, 2018); meaning that it has an 8% greater volatility than the market. General Electric’s (GE) beta is 0.71, so we would interpret that to say it is 29% less volatile than the market. If the market is up 5%, we could expect Apple to be up about 5.4% and GE to be up about 3.55%. The same would be true on the downside; Apple could go down further than the market, and General Electric would likely be down less.

It is essential to know what the “general market” is and during what time frame beta is calculated. When these two inputs change, the beta will change. Yahoo Finance uses the S&P 500 for the “market” and the last 5-year period for the timeframe.

Unsystematic risk is the risk not due to the market but due to the company itself or industry of the security. This type of risk can decrease with the diversification of securities; meaning if you avoid putting all your eggs in one basket you can decrease your overall risk levels outside the general market.  An example of unsystematic risk would be if Pfizer were to a drug on the market that suddenly started seeing severe side effects in the patients using it. The stock price of Pfizer would likely drop as a result. The general market would continue to move at its own pace as would stock in other sectors. The decrease in return or price is specific to Pfizer.

 

Comparing Returns to the Market

We know that investing in the stock market has risk associated with it but it also as return associated with it. When we study the return for a specific investment, let’s say Pfizer stock as an example, we can measure the return associated with Pfizer stock when compared to the market as a whole. We call this alpha. Alpha uses a broad benchmark, like beta, to compares the returns to the investment of choice. Alpha greater than 0 is beneficial but the higher the alpha the better the investment.

Statistical calculations can seem overwhelming for many, but the investment community has used them for many years to help them choose profitable investments for the wealthy. It is essential to have reliable and repeatable systems to help you decide your investments. Next week we will discuss some ways that you can apply to your portfolio to be sure you have made the right choices.

 


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