All investments are subject to pressures in the market. These pressures, or sources of risk, can come in the form of systematic and unsystematic risk. Systematic risk affects an entire investment type. Within that investment category, it probably can’t be “diversified” away.
Because of systematic risk, you may want to consider building an investment strategy that includes different asset types. For example, a sweeping stock market crash could affect all or most stocks and is, therefore, a systematic risk.
In the stock market, unsystematic risk is risk that’s specific to one company, country, or industry. For example, technology companies will face different risks than healthcare companies and energy companies. This type of risk can be mitigated with portfolio diversification, the process of purchasing different types of investments.
To be a savvy investor, it’s helpful to understand the risks involved with each asset class you’re looking to invest in. One way is to consider the standard deviation of an investment. Standard deviation measures volatility by calculating the dispersion (values’ range) of a dataset relative to its mean. The larger the standard deviation, the larger the range of returns.
Consider two different investments. Investment A has an annual return of 9%, and Investment B has an annual return of 6%. But when you look at the year by year performance, you’ll notice that Investment A experienced significantly more volatility. There are years where returns are much higher and lower than with Investment B.
| Year | Investment A | Investment B |
|---|---|---|
| 2000 | 14% | 11% |
| 2001 | 2% | 12% |
| 2002 | 22% | 12% |
| 2003 | 34% | 3% |
| 2004 | 5% | 8% |
| 2005 | -18% | -1% |
| 2006 | -21% | -5% |
| 2007 | 29% | 11% |
| 2008 | 6% | 1% |
| 2009 | 16% | 8% |
| 2010 | 22% | 4% |
| 2011 | 1% | 3% |
| 2012 | -4% | 0% |
| 2013 | 8% | 7% |
| 2014 | -11% | -4% |
| 2015 | 31% | 9% |
| 2016 | 7% | 5% |
| 2017 | 13% | 15% |
| 2018 | 22% | 14% |
| Average | 9% | 6% |
| ST. DEV. | 16% | 6% |
On Investment A, the standard deviation is 16%. On Investment B, the standard deviation is 6%. Although Investment A has a higher rate of return, there is more risk. Investment B has a lower rate of return, but there is less risk. Investment B is not nearly as volatile as Investment A.