Systemic Risk Vs. Idiosyncratic Risk

Jan 26, 2007 by

Today, the market went down. It went down in the U.S. (IYY: -1.14%), it went down in Asia (EPP: -2.29%), it went down in Europe (FEZ: -1.68%), and it went down in Latin America (ILF: -2.75%). This was a systemic decline.

When investing, one faces two types of risk: systemic risk and idiosynchratic risk. Systemic risk is the probability that the whole world market will have a negative (or positive) return. If you were a truly global investor, and bought every share that existed, you would be fully facing the systemic risk of the market. In all likelihood, you would make a positive return over time, as the system has a bit of an upwards drift to it.

An investor who has purchased IYY, EPP, FEZ, and ILF, has created a portfolio that is subject to substantial systemic risk, but little idiosyncratic risk. If a European publicly-held car manufacturer outperforms an American publicly-held car manufacturer or an Asian one, it does not matter much to this sort of an investor, as he has covered all of his bases (assuming that each of these indexes includes the corresponding car manufacturer). The price the investor pays for this is that if one manufacturer does well, and the others do poorly, he assumes both the gains and the losses, which may come to a wash. Nonetheless, he has little idiosyncratic risk.

Not every investor believes in reducing idiosyncratic risk. Imagine that there were only two companies in the cola industry, Coca-Cola (KO) and Pepsico (PEP).

As you can see from the five year price graph above, PEP (blue) is not perfectly correlated with KO (red). Thus, someone investing in just KO would be assuming idiosyncratic risk within the context of the cola industry. Late 2002 was a bad year for both Coke and Pepsi; there were some systemic factors hurting the cola industry. However, Pepsi’s success in 2005 appears to have been somewhat idiosyncratic; Coca-Cola did not have the same degree of positive success during the same time frame.

What’s the moral of the story? If you invested in both Coke and Pepsi a year ago, you would have made about a 17% return on Coke, and about a 12% return on Pepsi. Had you invested two years ago, your overall return would have been around 21% on Pepsi, and 18% on Coke. While the soft drink industry has done well over the past two years, the only way to eliminate idiosyncratic risk is to invest in all of the players. If Coca-Cola were to face a scandal and go bankrupt, it is likely that Pepsi would capture its market share. Thus, the person only owning Coke would lose all of their money, while the person owning both would only face the systemic risk facing the overall cola industry.

2 Comments

  1. I think the approach of reducing idiosyncratic risk is a sound one. It seems to me that you do have to pick the right ‘system'(s) to invest in. Using your above example, I think there is some significant systemic risk in investing in the cola industry, given the implication of soda in the obesity epidemic.

    I think this post is a sound explanation of the old adage “don’t put all your eggs in one basket”. I am getting ready to open my first investment account, and your post confirms my plan to build as diversified portfolio as possible. I am thinking about going with a total market stock index fund and want to eventually add a foreign index fund. Any suggestions?

  2. arif

    The blog covers all auspect of financial investment very nicely. I think not a single topic remains untouched. Also the arrangement of the needfull knowledge is very much interesting and beautifull. It is a good investment guide to all beginners. The blog provides useful information thanx a lot.

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