Investing in stocks aims to grow wealth, but along with gains comes the risk of losses. Investors build portfolios to reduce this risk and need a strategy to manage the risk of individual companies (unsystematic risk) and the risk of the market as a whole (systematic risk).
The goal of most people investing in stocks is to grow their wealth, but it’s not always possible to make a profit, and the expectation of profit always comes with the risk of loss. Investing in stocks is essentially a trade-off between risk and return, with the principle that the higher the return you expect, the higher the risk you must accept. To reduce this risk, investors usually organize a portfolio. In doing so, they need to consider both unsystematic risk, which is the risk that occurs regardless of the overall market conditions, and systematic risk, which is the risk that occurs in relation to market conditions.
The volatility and unpredictability of the stock market is a big challenge for investors. When the economy is uncertain or subject to rapid change due to external factors, investors are deeply concerned about how they can protect and grow their wealth. This is where the importance of portfolios comes into play. A portfolio is a strategy that reduces the risk of a particular asset by diversifying across multiple assets. With this strategy, investors seek to manage risk through a combination of assets rather than relying on a single stock.
Unsystematic risk is also known as firm-specific risk, which is related to the special circumstances of individual firms, such as labor strikes, business failures, or slow sales. Firm-specific risks are those that can occur unexpectedly in unpredictable circumstances and can be eliminated by diversifying across stocks. For example, investments concentrated in a particular industry can be greatly affected by an economic downturn in that industry, and to avoid this, investors should diversify their assets across different industries. In other words, the risk of investing in one company’s declining sales can be offset by the return of investing in another company’s growing sales, so investments should be spread across stocks or sectors that are not correlated with each other. Therefore, when a portfolio is composed of stocks from different industries, the unsystematic risk will gradually decrease as the number of stocks increases. This diversification effect can increase the stability of your portfolio over the long term.
Systematic risk, on the other hand, is related to the overall state of the market. For example, it comes from factors that affect many companies in common, such as economic fluctuations, inflation, changes in interest rates, and the political and social environment. Because systematic risk is about the stock market as a whole, it cannot be reduced by diversification methods that counteract unsystematic risk, so it is also known as non-diversifiable risk. For this reason, investors need to carefully observe market movements and analyze the impact of economic indicators or political events on the stock market.
So, is there any way to counteract systematic risk? Investors can counteract systematic risk by building a portfolio that utilizes the beta coefficient. Beta is a coefficient that measures the sensitivity of an individual company’s stock return to changes in the stock market’s overall return. It indicates how much the return of an individual stock changes when the return of the broader stock index changes by 1%. The beta coefficient can be described as the sensitivity of an individual stock’s return to fluctuations in the stock market as a whole. If the return of a stock A increases (or decreases) by 0.5% when the return of the broader stock index increases (or decreases) by 1%, then the beta coefficient of stock A is 0.5. If the return of stock B increases (or decreases) by 2%, the beta coefficient of stock B will be 2. Therefore, it is Stock B that is more sensitive to movements in the market as a whole.
The beta coefficient plays an important role in determining how investors should react to stock market volatility. For example, if an investor chooses a stock with a high beta coefficient during an economic boom, they can expect high returns. However, if an economic recession is expected, choosing stocks with low beta coefficients can help minimize losses. Therefore, when the stock market is booming, investors increase the proportion of investments in stocks with high beta coefficients. On the other hand, if a recession is expected, investors can minimize risk by increasing the proportion of stocks with low beta coefficients.
This strategic approach is an important consideration in constructing and maintaining a portfolio. Investors should consider their risk appetite, investment goals, market outlook, and other factors to adjust their portfolios and apply strategies that utilize beta coefficients in response to economic conditions. Finally, remember that the most important aspect of investing is continuous learning and keen observation of market trends.
