When making investment decisions, one must consider the expected returns and involved investment risks. Yes, a few other things too, but baby steps. We will get there in due course.
In assessing potential investments, most investors perform both quantitative and qualitative analysis.
Note that investment decisions include financial instruments such as stocks and bonds. But it also refers to any decisions you make when operating a business. Do I buy or rent my office space or production equipment? Do I develop and market a new product? Do I move into a new geographic region? These are also investment decisions.
Quantitative Analysis
Quantitative analysis is number crunching.
Think of it as quantitative equals quantity.
You take raw data, perform specific calculations, and arrive at a hard number.
Quantitative analysis attempts to be objective and without bias. That is, for a given set of data, different individuals should arrive at the same conclusion.
With investment risk, calculating the standard deviation is an example of quantitative analysis.
Some people fall in love with quantitative analysis. It is reassuring to get objective results that can be directly compared against multiple investment options. Plus it is nice to be able to “blame the numbers” when you make the wrong decisions.
For example, two possible investments both have 10% expected returns. You perform the proper calculations and find that investment A has a standard deviation of 5%, while investment B has one of 8%. You “know” that investment A is the less risky option. That provides comfort when choosing A.
While I agree that quantitative analysis is important, I am leery of relying solely on it.
As we saw, there are limitations to the use of standard deviations. The same is true for most quantitative analysis.
Often, historic data is a key input for quantitative analysis. Yet past results are no guarantee of future performance.
When modelling future results, variable inputs (e.g. inflation, growth rates, etc.) must be determined. These require forecasts and projections of the future. Even the best of estimates may not be wholly accurate.
While quantitative analysis is very useful, it should never be used as the only means of decision-making. You also need to deal with qualitative aspects to get the whole picture.
Qualitative Analysis
Qualitative analysis is more “touchy-feely” than quantitative analysis.
Whereas quantitative analysis tries to be objective, qualitative analysis is subjective.
Think of it as qualitative equals qualities of the investment.
There are no hard numbers that you can calculate in order to arrive at your decisions. The information is there, one just needs to know how to find it. Usually experience and intuition are key factors in arriving at the correct results.
What one person may discern may be completely different than another might find. Obviously this is an area where competent investment professionals can add value. The more experienced, knowledgeable, technically proficient an asset manager is, the better they should be to assess an investment’s “soft” characteristics.
Now do they get it right often? And/or at a cost to investors that is reasonable? Those are the concerns in the active management versus passive debate.
In the realm of qualitative analysis are the two major components of investment risk. Although they are called a variety of names, we will use the terms nonsystematic and systematic risk.
Each investment decision has components of both nonsystematic and systematic risk. If you can learn to identify the key subsets of these two risk components, you will have an advantage over others when making decisions.
Today we will briefly describe both components. In subsequent posts, I shall identify some of the more common subsets of each class and ways to deal with them.
Nonsystematic Risk
Nonsystematic risks are unique to a specific company, industry, asset, or investment.
Note that when I use the term “company”, for ease in writing, I shall also include sole proprietorships, partnerships, joint ventures, etc. under this heading. If there are any differences worth noting, I shall split them out at that point in time.
Nonsystematic risks may also be called specific, non-market, security-related, idiosyncratic, residual, unique, unsystematic, or diversifiable risk.
The oil company you invested in drills a dry hole. A key employee in your company quits. Your home’s hot water tank explodes, flooding your house. All specific risks.
Systematic Risk
Systematic risk is derived from risks that effect the entire market or a specific segment of the market. Systematic risk factors are far reaching and impact all companies or other investments to some extent.
These factors are not unique to the investment under consideration. They will impact a company regardless of how the company operated or manages its risks.
Systematic risk may also be called non-diversifiable, non-controllable, or market risk.
A global glut of oil drives crude prices down, which in turn lowers the value of your oil company stock. A hurricane hits your home on the Gulf Coast causing significant damage. These are more systematic and non-controllable risks.
Dealing With Nonsystematic and Systematic Risk
For passive investors (i.e., investors of financial instruments), minimizing nonsystematic risk factors is not difficult. By adequately diversifying your investment portfolio, you can effectively manage nonsystematic risks.
Some academics believe that by holding between 12 and 18 stocks (or bonds), one can achieve adequate diversification to eliminate nonsystematic risk. Yes, but they need to be the perfect mix of assets. When we discuss portfolio creation later on, I will review how to properly diversify an investment portfolio.
I think that for most readers living in the real world and not academia, you will need a few more investments to minimize nonsystematic risk. For example, perhaps 40 or more stocks with the right mix. If you only have investable capital of $100,000 you will own 40 companies each with $2500 in stock. The transaction costs, rebalancing expenses, and time to monitor 40 companies can add up.
However, if you invest in a single well diversified exchange traded or mutual fund, you can easily exceed 40 companies in one investment. Usually at very reasonable expense ratios.
Consider Vanguard’s Total World Stock ETF (VT). In this one ETF, you can invest in nearly 8000 companies, located in 47 developed and developing markets around the world. According to Vanguard’s fact sheet, that covers “more than 98% of the global investable market capitalization.” And the annual expense ratio on this fund is only 0.14%. Talk about inexpensive, global diversification (and minimization of nonsystematic or stock specific risk).
That is one of the main reasons that funds should form the core of most investors’ portfolios. You can get great diversification at low cost. Something that is very hard the less capital you have to invest.
For those managing a business, it is impossible to diversify one company. However, by being able to identify the nonsystematic risks, you can take steps to reduce their potential impact. We will look at the specific risks and how to deal with them in my next post.
As some of the alternate names suggest, systematic risk is more difficult to manage. Although sometimes called non- diversifiable or non-controllable risk, you can actual take measures to reduce this risk. Diversification, insurance, and hedging are examples of ways to address systematic risk. When we look at portfolio construction, I will make suggestions on dealing with systematic risk issues.
Next up, a deeper examination of nonsystematic risk.
