Wait, what did you just call me? A guy I knew when I was young used to tell me, “Kid, you are using $10 words on a 10¢ budget! Speak English, please.”
Ok, here is the Webster definition:
- Systematic: “done or acting according to a fixed plan or system; methodical.”
- Idiosyncratic: “of or relating to idiosyncrasy; peculiar or individual.”
Fine you say. This is great for people who are competing in a spelling bee, but why are you telling me about this? Because, if you are investing and saving for your retirement or other goals, these concepts could have a big impact on the outcome.
Here is the point . . . according to “efficient market theory” (basically, lots of research by very smart people that has led to a number of Nobel prizes) you can diversify away idiosyncratic risk, but you can’t diversify away systematic risk.
In layman’s terms, idiosyncratic (or unsystematic) risks are things related to a specific investments, such as a single company or single market segment, for example real estate or energy. These risks can be minimized or eliminated with diversification, that is by putting your eggs in many different baskets.
On the other hand, systematic risks are things that are embedded in the nature of the market, such as interest rate changes, or inflation, and therefore cannot be diversified away. They are inherent to investing. No matter how many different baskets you put your eggs into, this is the risk you can’t get rid of.
So, now that you know what they are (and that I’m not actually trying to offend you), which one are you? Are you A) systematic or B) idiosyncratic?
How you answer this question probably provides a strong indication about how you approach the topic of investing and financial planning. If you believe you can consistently “beat the market” by picking winning stocks, you might answer B. If you instead believe that the best strategy is to regularly invest in a well-diversified portfolio, you’d probably answer A. If you are a gambler, you are idiosyncratic. If you are an investor, you are systematic.
Here is the reason. If you approach the topic as an investor, your interest is primarily in maximizing your return (the money you can make) and minimizing your risk (the chance of losing it). Why would you take any unnecessary risks when you don’t have to? The only logical reason for doing so is because you believe that the chance of making more money (your return) is greater than the chance of losing it (your risk.)
Unfortunately, a lot of research has shown that human decision making is consistently biased (flawed). We think we are making a good decision, but are in fact negatively influenced by biases that we aren’t even aware of. For example, research has shown that in the stock markets individuals tend to hold onto losers and sell winners. That isn’t a great strategy for making your money grow.
The only way to remove these biases is to take the human decision makers out of the process, and strictly rely on a systematic process. This is why over the last 100 years we have seen a strong trend away from investing in individual stocks and towards investing in mutual funds and well diversified portfolios, reflecting that investors are trying to reduce their idiosyncratic risks.
So, now back to my original question: Are you systematic or idiosyncratic? And which one would you now prefer to be?