Stock investment risk: Understanding systematic and idiosyncratic risks

Open full sized image

Caution: Risky Investing Ahead

© Jon Hicks—Stone/Getty Images

Companies like to highlight their growth prospects. So do the analysts who tout their shares. But when it comes to staying at the forefront of investment risks, the burden is on you.

Investing can be a bumpy ride—markets go up and they go down. When they drop, they tend to drag down the return on your investments. Market downturns can be difficult to stomach. But if you’re aware of the investment risks you might face and take a few steps to minimize and mitigate them, it may be easier to get over the bumps on the road.

The goal of investing in stocks is to maximize your returns relative to risk (or volatility). A company that’s experiencing strong growth is likely to see its stock price rise, which in turn gives investors a return on their investment. Some stocks pay dividends, which can provide additional income.

Although stocks have generated higher returns than bonds over the long term—about 40% higher, according to research by Morningstar—stock prices can be sensitive to changes in the competitive landscape, costs, and overall economic sentiment. These factors tend to run in cycles, and during the negative phase of a cycle, stock prices can fall—sometimes dramatically—creating a volatile environment.

Investing in stocks brings risk in two broad categories: systematic and non-systematic.

Systematic risks. Systematic risks can’t be avoided. Generally they involve macroeconomic events that impact the entire financial market. Systematic risks include:

Non-systematic (aka “idiosyncratic”) risks. Non-systematic risks are those that affect a specific stock or sector. Non-systematic risks include:

Given the different types of investment risks you face, how can you reduce your exposure to market volatility? You’ll need to monitor company fundamentals and economic indicators.

Fundamental stock analysis means looking at the overall financial health of a company, often by analyzing key ratios such as price-to-sales (P/S), price-to-cash-flow (P/CF), and price-to-book (P/B). These ratios can help you determine if a stock’s price is over- or undervalued, which is a factor in the risk of an investment.

Stock valuation. The price-to-earnings (P/E) ratio is useful in assessing a stock’s value. P/E tells you whether a stock is trading at a premium or discount in relation to its earnings. A fast-growing stock might trade at a high P/E ratio compared to its competitors, especially if revenue and earnings are growing quickly. The downside: One bad earnings report could tank the stock price.

Earnings reports. Markets are driven by earnings. Publicly held companies release earnings each quarter. They typically hold a press conference or earnings call to discuss the numbers and offer forward guidance—an outlook for the coming quarters or the remainder of the year. Investors can use this info to assess the company’s profitability, cash flow, growth potential, and competitive environment.

Key indicators include year-over-year earnings per share and revenues, as well as how future guidance compares to analysts’ projections. These offer a general idea of how the stock is likely to perform going forward. But there can be surprises. No indicator can predict a company’s fundamental health with 100% certainty. They can, however, help reveal the strength of a company—a helpful clue in assessing the riskiness of an investment.

You’ll often hear economic indicators such as the monthly employment situation (“the jobs report”), retail sales, and inflation mentioned in the news. Economic indicators tend to move the markets, some more than others.

Unemployment data gives you an overall idea of the jobs market—how many people are looking for work, how many are working, how much they’re getting paid, and so on.

Retail sales indicate consumer spending. More spending is an indication of strong economic growth, which in turn means strong corporate profits and a strong stock market. But a strong economy could put upward pressure on consumer prices—in other words, inflation.

You can track inflation by following the Producer Price Index (PPI) and Consumer Price Index (CPI). These indicators measure the change in producer and consumer prices, respectively. If inflation runs too hot or spending too cold, the Federal Open Market Committee (FOMC) can step in to tweak its interest rate policy.

Other indicators that can help identify general economic trends include housing numbers, consumer confidence, and GDP. A rise in housing starts indicates strength in the construction industry; more confident consumers means more spending; and GDP numbers clarify trends in the overall economy.

Systematic risks may be difficult to avoid, particularly for long-term, buy-and-hold investors. However, you may be able to minimize non-systematic risks by diversifying your assets across different sectors or asset classes. That way you can spread your risks among higher-risk and lower-risk investments. You can also invest a portion of your portfolio in bonds and other fixed-income investments, which sometimes—although not always—perform better when the stock market loses its footing.

When you invest, you can’t avoid investment risk. But by tracking some of the broader financial and economic aspects, you can make the investment journey a little more comfortable.