How ETFs can help you manage risk
Risk is defined as an exposure to a possible gain or loss of something of value, such as your health or wealth.
Given the future always has with it an element of uncertainty, each one of us has to regularly deal with the concept of risk in our day-to-day lives. In investing, how well we manage risk is often the key factor that determines our long-term success.
Famed investor Howard Marks believes that dealing with risk is the most essential element of investing. He believes in a three-stepped approach to risk. The first step is to understand the risks. The second step is to recognise when those risks are high. And the third step is to control and manage those risks.
When markets are flying, investors as a whole, often take greater risks. However, when markets fall, those same investors tend to become risk averse. It should actually be the other way around. When markets are high, risk aversion should also be high, but when markets fall, we should be looking to take advantage of opportunities.
In investing, risks can be lumped into two main categories. There are ‘unsystematic risks’, which are risks that relate to a specific stock or sector, and there are ‘systematic risks’, which are risks that impact the market as a whole, such as high inflation or a war.
Unsystematic risks can be mitigated with a well-diversified portfolio, such as with broad-based ETFs. Systematic risks however are a lot harder to mitigate, but there are still some approaches that work.
Unsystematic Risks
Unsystematic risks are risks that are stock specific or related to a sector.
For example, if you own shares in company XYZ, you carry a number of risks. These include the risk that the company will not reach its profit targets, or the company loses a key contract, or a product is recalled, or the company commits fraud.
Unsystematic risks can also include sector wide risks. For example, there’s the risk that extra regulation is brought into an industry (such as banking), or the risk that a super-profits tax is introduced into an industry, such as the mining industry.
Unsystematic risks can be mitigated through diversification, which helps to smooth out portfolio returns if there is a fall in one stock or sector.
In the current market, we can see the advantages of diversification, with several sectors such as technology and healthcare struggling, whilst energy and utilities have performed well. Diversification helps to smooth out an investor’s overall returns, especially over the long-term.
Systematic Risks
Systematic risks are external risks that affect the market as a whole.
Examples of systematic risks include sizeable rises in inflation and interest rates, as we see at the moment. The GFC and collapse of the US housing market is another example of systematic risk. Other types of systematic risks include natural disasters, war, terrorist attacks or pandemics such as Covid-19.
Systematic risks are a lot harder for investors to mitigate, but there are some things that can be done.
One of the best approaches for mitigating systematic risks is to have a correct asset allocation strategy. This means that your portfolio includes a variety of asset classes such as fixed interest, cash, real estate, infrastructure, and local and international shares. If say shares fall, a well-structured portfolio will be less impacted, as it holds other asset classes such as cash.
Another approach to mitigating systematic risks is to combine a well-diversified portfolio, with patience and hanging in there during the tough times.
If we look at the All-Ordinaries chart over the last 100 years, we can see that there have been a number of downturns caused by systematic risks. These include the Great Depression, the Oil Shock of 1973-74, the crash of 1987, the tech wreck, the GFC, and the Covid crash.
In every single downturn, the market recovered and went on to make new highs, and that’s why long-term investing works.
ETFs
The beauty of broad-based ETFs is that they are a cheap way to give you the wide diversification that is needed to help you minimise risk.
If your approach also includes correct asset allocation, and the patience to ride out volatility, it can provide you with the best approach for minimising the risks of investing, while still enjoying the benefits that long-term investing can bring.
The InvestSMART Diversified Portfolios combine the best ETFs available in each asset class. Click here to view the portfolios and click into each to see the ETFs used.
Frequently Asked Questions about this Article…
In investing, risks are generally categorized into two main types: unsystematic risks and systematic risks. Unsystematic risks are specific to a particular stock or sector, while systematic risks affect the entire market, such as inflation or geopolitical events.
ETFs, especially broad-based ones, offer a cost-effective way to achieve diversification, which helps mitigate unsystematic risks. By spreading investments across various sectors and stocks, ETFs can smooth out returns and reduce the impact of any single stock or sector's poor performance.
Unsystematic risks are specific to individual stocks or sectors, like a company failing to meet profit targets. Systematic risks, on the other hand, impact the entire market and include factors like inflation, interest rate changes, and global events such as pandemics or wars.
Diversification is crucial because it helps spread risk across different investments. By holding a variety of assets, investors can reduce the impact of a downturn in any single stock or sector, leading to more stable overall returns.
Mitigating systematic risks involves having a well-structured asset allocation strategy that includes a mix of asset classes like fixed interest, cash, real estate, and both local and international shares. This diversification helps cushion the impact of market-wide downturns.
Asset allocation is key to managing risk as it involves distributing investments across various asset classes. This strategy helps balance risk and return, ensuring that if one asset class underperforms, others may offset the losses, leading to more stable portfolio performance.
Patience is vital in long-term investing because markets naturally experience ups and downs. Historical data shows that despite downturns, markets tend to recover and reach new highs over time. Staying invested through volatile periods can lead to significant long-term gains.
Broad-based ETFs provide diversification by investing in a wide range of stocks across different sectors and industries. This broad exposure reduces the impact of any single stock's poor performance on the overall portfolio, helping to manage risk effectively.