Risk Is in the Eye of the Beholder

What I’m Drinking as I Write – Dead Eye Coffee

  • 3 shots of espresso
  • 1 cup of coffee
  1. Brew, combine, and enjoy

There are two main types of risk: systematic and unsystematic. Systematic risks relate to the overall economy and cannot be eliminated through different portfolio logistics such as diversification. Unsystematic risks are stock-specific and can be eliminated with portfolio management. Most investors are mindful that some level of risk will always be present in their portfolio. Yet, when the market is down 5% off its highs, some investors panic-sell. Why is this? In Thinking, Fast and Slow, psychologist Daniel Kahneman, states:

“…. people’s emotional evaluations of outcomes, and the bodily states and the approach and avoidance tendencies associated with them, all play a central role in guiding decision making.”

In this context, investors assume when bad news is released, there is an additional reason to be concerned, therefore implying additional risk. In an effort to avoid this additional risk (and assumed additional losses), some investors will choose to sell and wait for a better time to buy back. Yet, has the investor’s risk really changed?

As previously mentioned, the two categories of risk are based on factors we can control (stock-specific news), and factors in which we have no control (economic-specific risks). The term beta is used to measure systematic risk, with a coefficient of one to measure the amount of risk in the overall market; anything below one is essentially less risky and vice versa. 

Let’s assume Investor A has an extremely balanced portfolio, and owns stocks, which are further diversified into small, mid, and large-cap; developed and emerging international; combined with bonds, further diversified among credit ratings and duration. Investor A has done a great job at eliminating unsystematic risks and need only be concerned about systematic risks. 

Investor A’s Portfolio:

Investor A’s portfolio has a beta of 0.983, meaning that it will theoretically move up or down less than the market (1.7% better or worse) on any given day. This is the level of the investor’s total risk (assuming unsystematic risk of 0). So did this investor’s risk really change when the market sold off in 2020 from the global economic (systematic) news of COVID-19? The S&P 500 peaked on February 19, 2020 and proceeded to decline 34% to its low on March 23, 2020. What did Investor A’s portfolio do during that same time period?

This investor’s portfolio performed nearly 17% better (holding period return of -28.5% vs the market’s -34%) over the same time frame. Although this investor most likely did not feel they were outperforming the market at the time, they were, and managed to do so with less risk than the overall market (historical 0.945 beta during the time period vs market’s 1.0). 


When new headlines emerge and the market becomes more volatile, investors often begin questioning their portfolio or look for further reasons to change their strategy. They might choose to abandon their riskier assets (equities) and flow into “safer” assets (fixed income). There are only two times an investment strategy should be changed in these situations. The first is if you hold an individual stock with increased unsystematic risk directly tied to the new information, which needs to be reevaluated accordingly. The second is if your news has changed. Did you recently lose your job, get a promotion, have a child, or retire? Your investment strategy should be reviewed and adjusted as major events occur in your life to continue to plan for your long-term goals.

When you start investing, set a well-diversified, balanced investment strategy that meets your overall financial goals and stick with it. Do not doubt yourself when others are fearful, and do not flatter yourself when others are greedy. Most importantly, do not assume near-term risk will lead to long-term losses. The systematic risk has been and always will be there. Do not let the events attracting disproportionate amounts of attention lead you to thinking they are more severe in the long-run than they really are. As Jonathan Haidt so eloquently put it in his Psychological Review

“The emotional tail wags the rational dog.”

Happy Sipping!



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