Investors have a love-hate relationship with risk. We feel warm and fuzzy about it when it works in our favor. We loathe it when it works against us. Ultimately, we are married to risk, for better or worse, until death do we part. We need to take risks to meet our investment goals. To do this effectively, we must understand the risks we take and how to manage them.
Systematic risk
Systematic risk is like gravity. It is a fundamental force that shapes everything around us. Also known as market risk or undiversifiable risk, it is typically the biggest risk that investors face. Systematic risk is driven by two key economic variables: growth and inflation. The long-term returns of virtually all assets (we'll set aside cryptocurrencies and Beanie Babies for now) are a factor of these two inputs. If the economy grows and growth translates to rising cash flows for companies, equity investors will be rewarded for assuming risk. If inflation runs rampant, bondholders will be punished.
Like gravity, there is no avoiding systematic risk, but investors can manage it. The primary means by which we can govern our exposure to systematic risk is through asset allocation. Asset allocation is like the main tuning knob on a stereo receiver. Changing your mix of stocks, bonds, and cash is the easiest way to move the dial on the level of systematic risk that you assume. Want to take less risk? Turn the dial toward bonds and cash. Want more? Spin it toward stocks.
The right balance is inherently personal. In theory, it will depend on your willingness and ability to take risk. In practice, measuring these is part art and part science. Your judgment of your willingness and ability to assume risk will likely fluctuate depending on things like your mood, recent market performance, and changes in your personal circumstances. As such, it's important to regularly reassess your risk appetite and your risk budget. Your asset allocation may not be (or might not feel) as appropriate today as it was when you last reviewed it on an empty stomach one day in September 2015 after U.S. stocks had slid nearly 10% over the two months prior--just before you retired.
You can also manage the level of systematic risk you take within a given asset class. Investment selection is akin to the fine-tuning knob on a stereo receiver.
Idiosyncratic risk
Systematic risk is general. Idiosyncratic risk is specific to a firm and is not dependent on how the market moves. Growth and inflation drive systematic risk. Idiosyncratic risk springs forth from an infinite number of things. Will Tesla (TSLA) be able to meet its latest Model 3 delivery targets? Will Lyft (LYFT) ever turn a profit? The answers to these questions depend on the answers to countless subquestions, virtually all of which are impossible to answer precisely. This mix of Rumsfeldian known knowns, known unknowns, and unknown unknowns gives rise to idiosyncratic risk. These risks are specific to the firms facing them and the markets in which they operate. The potential gains for assuming this narrower form of risk are greater than market risk, but so are the prospective losses. The best means of managing idiosyncratic risk is to simply diversify. Moving from a one-stock portfolio to a 20- or 30-stock portfolio diversifies away more than 90% of the idiosyncratic risk of a basket of individual equities, leaving mostly market risk. A two-fund portfolio combining Vanguard Total World Stock ETF (VT) and Vanguard Total World Bond ETF (BNDW) would own more than 30,000 securities. Owning a diversified portfolio of funds leaves investors facing (maybe) a shred of residual firm- or issuer-specific risk.
My favorite ETFs for dialing down risk
The ETF menu features an expansive number of finely tuned instruments that allow investors to directly control the amount of systematic risk they take within their portfolios. This spread ranges from total stock market funds, to low-volatility emerging-markets stock funds, to short-term government-bond funds.
ETFs underpinned by broad-based market-cap-weighted benchmarks allow investors to tap into a full spectrum of asset classes with low minimums (a single share) and low costs. These funds all but wipe away idiosyncratic risk. Within those same asset classes, funds allow for ever-more precise ratcheting of systematic risk. In theory, being able to fine-tune risk levels should help to hedge against behavioral risk. And the ETF wrapper itself serves as a means of managing tax risk, allowing investors to defer realizing more of their capital gains for longer in taxable accounts.
Exhibit 1 lists some of my favorite ETFs for managing risk. This list contains a mix of broadly diversified, market-cap-weighted funds and explicitly risk-oriented or otherwise more-narrow alternatives. You can think of the former group as the main tuning knobs on your risk dial. The others are fine-tuners.
These funds' ability to move the risk needle is proxied here by their beta, a measurement of their sensitivity to movements in the broader market. The broad-based funds' betas are generally close to 1. This means they'll generally be as volatile as the market proxy used to calculate their betas. The fine-tuners below all have betas of less than 1. These are good options for dialing down risk within a particular asset class. The iShares Minimum Volatility funds aim to produce the least-volatile portfolio of stocks possible from their parent indexes. As these funds' trailing five-year betas versus their respective market proxies indicate, they've been effective in doing exactly that.
On the fixed-income side of the ledger, investors have an even finer set of implements to manage their exposure to the primary drivers of risk: credit and duration. Schwab Short-Term U.S. Treasury ETF (SCHO) throttles back on both, investing in issues with no credit risk at the short end of the yield curve.
