Risk is something that we field questions about almost daily. About 50% of our clients and customers bring up the topic of risk at least one time during one on one sessions or webinars. The reality is, financial media has trained us to be concerned with risk and always worry about if we have too much risk or not.
We are here to tell you; it is not that hard to “manage your risk.” It is one of the simplest things we as investors can do because it is one of the few aspects of investing we have complete control over.
We have been asked the question “which one of the following is an example of systematic risk?”. This is an article and concept we are very much looking forward to flushing out as the idea of risk is just too much for some people to handle.
Risk is so overblown it is very annoying to us. Before we can talk about what risk is and answer the question “which one of the following is an example of systematic risk?”, we have to speak about why investors focus so much on risk.
We talk about this a lot, and if you are a first time reader of this blog, this will not be the last time you heard this concept too.
The goal of Wall Street is to gather assets and charge fees. Period.
The goal is not to make money for everyone. It is to take your money, keep you investing, and continue to charge you fees for doing so.
And how exactly does Wall Street make sure this happens? By scaring the crap out of you!
We turn on financial media and any time the S&P is not up, the world is ending. People are buying Treasuries. or Gold, or the VIX. Financial media screams and yells about this and every news source you read the next day will undoubtedly have headlines that speak about the “crash” in the market even if it was just down one percent.
While financial media does not get a kickback from Wall Street when Wall Street takes your money and charges you fees, risk and every news anchor getting worked up and “scared” does attract eyeballs.
Financial media loves screaming about risk to attract eyeballs, while at the same time Wall Street loves talking about risk until they are blue in the face because it causes individual investors to believe they cannot manage their money themselves. And when an individual investor feels they cannot manage their money themselves, what happens? That’s right. They give their money over to the “experts” who can manage “risk,” who also is excellent at charging them fees.
Why? Because these so-called “experts” are expected to return profits over and over again, and you and I are not. This is ridiculous.
In short, talking about risk, which is nothing more than you potentially losing money, is an incredibly useful idea for the powers that be.
What is Risk Then?
When I think about risk, there are a few types that I can think of:
- The risk of being outperformed by the market
- The risk of losing money
- The risk of not having control over my portfolio
For the risk of beating the market, there is nothing we can do about it. And because there is nothing we can do about it and we do not have any control over it, we do not worry about it.
Out goal is investors is to take our every single penny from the market we can each and every day. If the overall market takes out less or more than us, it still does not change our mission.
However, we can take systematic risks that will prevent the risk of losing money and the risk of not having control over our portfolios.
The market is not risk free. Everyone knows this. Economic conditions change from day to day. While this can seem overwhelming, the truth is we have total control over our portfolio and investment structure at all time.
Let me explain.
Our goal as investors is to again, make as much money as we can every single day. Period. Nothing more.
The way we do that is by making continuous, systematic risk decisions. But the key here is to do them the right way so that we do not lose control over our investments and our total portfolio.
How do we do this?
We do this my keeping the size of our current investments in check. Or, week keep our investments small.
Again, we have TOTAL control over our investment size. The market will do whatever it wants, but if we continue to keep our investment size small, we will have a difficult time caring about risk because our small investments prohibit us from having a portfolio that is full of risk.
Which One of the Following is an Example of Systematic Risk?
We are going to look at two portfolios here and figure out exactly which portfolio is taking a systematic risk.
When comparing these two portfolio, we do not care about things like stock beta or stock diversification because in taking systematic risks, those things matter much less than trade size.
Again, the security doesn’t matter. What is important is our size. If we look at these two portfolios, we see portfolio one comprised of five stocks each with 20% allocated to each of them.
On the other hand, portfolio two shows ten stocks, each with 10% of the total portfolio net liquidation value assigned to them.
Which one of the following is an example of systematic risk? Portfolio two is a case of systematic risk.
It is one big math game ladies and gentlemen. Pure math speaking, portfolio one has a 1 in 32 chance of losing the entire value of the portfolio.
While at the same time, portfolio two has a 1 in 1,024 chance of losing the whole value of the portfolio. All because portfolio two allocated half the trade size of portfolio one.
Wrapping It All Up
Again, sectors, beta, diversification, security, stock, all of these topics matter much less than size. Size can wipe us out while at the same time can keep us around and in the markets forever if we utilize size properly.
And the best part is, we have total control over our investment size. We have complete control over the size we allocate to each investment. In the crazy game of economics and financial markets, there are very few levers we have complete control over. The good news for us is, we have complete control over our investment size.
Which one of the following is an example of systematic risk?
The answer will ALWAYS be the one with smaller investment size.