Understanding the Two Types of Market Risks

There are some mistakes worth mentioning. While teaching financial Planning at Purdue University in Lafayette, I found two words that sound very familiar but are quite different and the author of the text book interchanged them. The revelation was so severe in my opinion that it lead to me eliminating the book for the next six and half years of my teaching career. Today I heard another market analyst make the same mistake: Systematic and systemic may look alike and may even sound alike but their meanings are worlds apart.

Systematic refers to the normal process of investing that essentially argues the majority of your investment return is based on the asset class or broad market rather than the particular stock or bond. The broad belief is that roughly 70% of your return is related to systematic risk, meaning the bulk of its price movement is caused by the overall market. Always remember the word “risk” used in the investment world translates to getting something other than what you expected. It could be good or bad. Systematic risk can indeed impact a portion of your portfolio and the best medicine is diversification both in individual security selection and asset class exposure.

Systemic risk is when one part of the economy has an issue and the entire market craters.  2008 was a perfect example. At the Financial Enhancement Group, we noted systematic risk in the financial service sector in November of 2006. We were fortunate enough to avoid all the systematic risk that came from that particular sector when the financial crisis emerged. The challenge was the housing crisis was not systematic but rather systemic. It wasn’t just financial stocks that took a beating but the entire market almost collapsed. Thus we shared in the pain in our portfolios as the systemic shock wrecked through the markets. Not to be a fear monger but the system was much closer to a collapse than many care to admit.

Today we are surrounded with geopolitical concerns of all sorts.  Venezuela, trade talks, North Korea meetings, Brexit, and now Italy and Spain have joined the crowd of issues.  The young man on the news today said that “Italy is a systematic issue that could harm major economies around the world.” His implication was Italy can bring down everyone which is systemic in definition. He inter-changed the words. We don’t agree at this point with his dire analysis but Italy does have issues.

There are two factions that want Italy to spend more money on pensions and other benefits for the people than what they can seemingly afford.  Providing a helping hand is a good thing but they are in debt to the tune of 132% of GDP according to Bill Witherall of Cumberland Advisors.

Italy is faced with a crisis of direction. Its northern neighbors – Germany particularly- expect Italy to be governed with some fiscal responsibility. The people, not that different than the populous of our own country, want free benefits and more money. Obviously there has to be a stopping point at some time.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see our Disclosure page for the full disclaimer.

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