What You Need to Know About Systematic Risk

We're a stock-picking company at The Motley Fool, and we tend to sing the praises of investing in individual companies for the long term -- but that's not to say that stock-picking is without its fair share of risks.

In this segment from Industry Focus: Healthcare analysts talk about systematic or market risk -- what you need to know about it before investing, what it could mean for your portfolio, and how you can work to mitigate it.

A full transcript follows the video.

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This video was recorded on Oct. 25, 2017.

Kristine Harjes: I think something that's important to recognize is, there are two widely established categories of risk that we're dealing with here. There's something called systematic risk, that's also known as market risk. That's something that's an event that could affect the entire market. So this is why you diversify across different asset classes. Say the stock market crashes -- that's an example of systematic risk, where every single one of your stocks is likely to plummet because of that. But you also have something called idiosyncratic risk, and this is also called specific risk. This is something that is specific to a single industry or even a single asset. We were talking about boom or bust biotechs, so that would be something like your drug fails in a clinical trial, so that's going to really hamper the stock. And depending on how much of the company's value is tied to that single drug, you could be erasing 90% of the market cap, something like what we saw with Ophthotech, where their main and only drug completely flopped, and it wiped out almost all of the market cap of this company.

However, there's also idiosyncratic risk that's specific to an industry as a whole. This could be something like, if there was some sort of drug price reform, and all of a sudden, all drugmakers are required to have a cap on their margins, or something crazy like that. Political is an obvious example of this, the political risk that could happen to an entire industry. But you could also get things like consumer spending, for example, that could hit retail as an entire sector really hard if all of the sudden unemployment goes up, and people don't have as much discretionary income anymore. The different types of risk are important to understand because it makes you think about how you're not just diversified because you own 15 to 25 stocks. You also need to figure out, how highly correlated are those stocks, and are you attacking different strategies with them? Are you hitting different geographies? Are they made up of different market caps?

Todd Campbell: Right, which, obviously brings you to the idea of, should I own international stocks as well? There are a lot of ways to make sure you're not too correlated. Usually, when you talk about correlation, you're comparing it to the benchmark, so, we'll say the S&P 500. You can run correlation pretty easy using Excel spreadsheets, and calculate those things out on your own. Which, of course, it's much easier to do if you have a portfolio that's only 12 to 15 names. And you can see just how much risk you're taking on. You can also, just by going to Yahoo finance or some of these other sites, you can check the beta, which shows you how much the stock will move when the S&P also moves up or down. So, you can find that, if I have a lot of beta in my portfolio -- so let's say I have a beta of 2; that means it's going to move 2 times how the S&P moves.

Harjes: On average.

Campbell: On average. So I'm exposed to a significant amount of risk if the market tumbles, or whatever. Then, you can also do correlation for the individual industries in healthcare, and say, "Are my biotech stocks too heavily correlated to my drug makers, my medical equipment stocks, my medical instrument stocks, how the insurer stocks fit in vs. biotech, etc. So considering beta, considering correlation, those are ways that you can make sure that all of your eggs aren't in the same basket.

Kristine Harjes has no position in any of the stocks mentioned. Todd Campbell has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.