Real Estate Matters | Is diversification good? Systemic vs. unsystemic risk

Sam Lee

Risk.

Just seeing that word may have made you balk. It’s an uncomfortable and irksome word for most people, and if we think about it too long it can make the palms sweat.

We mostly think of risk as being one dimensional. Something is either risky, or it’s not. But like most things in life, risk comes in different shapes and sizes.

In the securities investment world, risk is often separated into two kinds – systemic and unsystemic. There are many ways to differentiate between the two, but for our purposes we will stick to two differences. Systemic risk is market-wide and undiversifiable, while unsystemic risk is business- specific and diversifiable.

Basically, systemic risk is built into the system and affects the entire market, such as interest rate risk or the peaks and troughs caused by market cycles.

Unsystemic risk is specific to the particular industry, business or investment, such as the risk of the company you invested in going bust from mismanagement, and can generally be mitigated to a degree through diversifying your portfolio.

Your total risk is the combination of the systemic and unsystemic risk.

To raise an example closer to home, say that you walk into a local casino as a forced participant at a Roulette machine. You are only allowed to bet on either red or black where each bet can be considered to be a mini business investment with an ROI of either 100% or -100%.

In this oversimplified example, the unsystemic risk here would be betting on the wrong colour and losing all of your money, and the systemic risk would be the risk of the Roulette machine breaking down and you losing your money by default.

If you just pick a colour and put your chips down, you would be exposing yourself to both the systemic and unsystemic risks, but you also enjoy the potential upside of doubling your money. But if you are a risk adverse investor, you can diversify away ALL of the unsystemic risk by betting on both red AND black.

However, systemic risk exposure is not mitigated and if the machine breaks down or the ball lands on 0, you will still lose your money.

The crucial thing to take note of here is that while the old adage of “Never put all of your eggs in one basket” might help you decrease unsystemic risk, you are also diversifying away the potential upside as much as the downside. If you bet on both red AND black, you’ll never make any money, but you still might lose some!

That’s why when we at JML make investments into the UK we go by Andrew Carnegie’s philosophy of “Put all of your eggs in one basket, but watch that basket very carefully” instead of being overly worried about diversification.

We conduct careful due diligence upfront to make sure that the deal makes sense to begin with and make sure we know what we are doing in order to minimize the downside and still maximize the upside for clients and our own investments.

Sam Lee is a marketing manager and property consultant at JML Property.  JML was established in 1994 and offers Investment Property & Homes. It specializes in managing properties for owners and investors, and providing attractive and comfortable homes for tenants.

www.JMLProperty.com

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