Systemic risk has a bad reputation in the marketplace. As an investor, it represents all of the aspects of your portfolio that are beyond your control (ie. Cannot be hedged or diversified out of existence), and therefore represents the risk of your portfolio.
However, I find that it is generally over-generalized as a pervasive force. Realistically, it’s not systemic risk that poses the greatest threat to your portfolio, but non-systemic risk. From my perspective, systemic risk represents the ‘doomsday’ risk that involves the collapse of human investing as we know it (which, for the right price, can also be hedged through some more modern financial innovations).
Given that such a financial apocalypse results in everyone else losing as much money as you have (because everyone has lost everything), all systemic a systemic collapse presents to me, from a theoretical perspective, is the risk that I will only be able to match the market’s performance over the long term. From a much more practical perspective, I’m far more afraid of two specific kinds of nonsystemic risk:
- The non-systemic risk that I don’t know about or understand can (and will) always be ready to take me on a roller-coaster ride if I haven’t done quite enough due-diligence with my portfolio.
- The non-systemic risk that I know about and understand, but cannot afford to negate, will keep me awake at night for the entire duration of the period. Between paranoia and ignorance alone, a personal investor has enough risk in their portfolio at any given time to give their advisor a heart-attack.
Take the risk of default as an example. What if the company, whose stock your holding, suddenly declares bankruptcy? Is there any way to protect yourself against this risk, or is it systemic? What about your broker, what if they go bankrupt? Is 100% of your capital at risk simply if your brokerage failed to run a proper practice? How about expropriation, or even the fundamental collapse of the stock market itself (none of this ‘recession’ business, I’m discussing a scenario where the S&P goes to zero). All of these are real issues for your portfolio to contend with, but is it even possible to outsmart them?
While the issue of the affordability of diversification is a lengthy one that I will save for a later date, the topic of ignorance is one that is dear enough to my heart that I would like to dedicate the next few posts to it. By the end of this week’s series, you’ll be familiar with a sub-set of major non-systemic risks that normally disguise themselves as unsolvable systemic risks. At the end of each article, I’ll include an accessible strategy for protecting your portfolio from the discussed threat.
