During my conversations with investors, the topic often turns to investment risk. Most investors understand that they need to take risk in order to earn a return above what is available from the money markets. While there is an almost endless variety of risk in investing, most conversations revolve around the risks of investing broadly in the stock and bond markets.
I’ve found that most investors understand that investing in stocks is riskier than investing in bonds. But of course, like in many subjects, the devil is in the details. Not all risks in the stock market are worth taking in the pursuit of higher returns. This is especially true if you are trying to pursue a long-term investment strategy designed to achieve your specific goals.
There are two types of risk that you must understand in order to be a successful long-term investor in the stock market. They are systematic and unsystematic risk.
Systematic risk, sometimes referred to as Market Risk, is the risk that includes macroeconomic conditions affecting all companies that cannot be eliminated through diversification. Unsystematic risk includes industry and company specific risk. These risks can be reduced through diversification.
The total risk in the stock market includes both types of risk. Investors however should not expect to be compensated for bearing unsystematic risk and the academic research has proven that this is the case.
As a result, investors should broadly diversify their portfolio in order to reduce unsystematic risk and harvest the returns available from bearing systematic risk.
If you would like to learn more, I suggest you read Against the Gods: The Remarkable Story of Risk. This excellent book by Peter L. Bernstein explains the history of thought about risk and probability. I promise it is less dry than it sounds and well worth reading.