Many clients who come to see us for the first time own some shares. These shares might have been inherited, received when an old building society became a bank or bought through a company share save scheme. Some people also buy and sell shares on a regular basis because they like to dabble in the stock markets.
Most of these new clients have the shares of just one or two companies in their portfolio, rather than having a broad spread of different companies and different industries.
By owning the shares of just one or two companies you are exposed to something called “non-systemic risk”. This is the technical term for when an event affects one company without affecting other companies.
In this post I will explain this concept in more detail and suggest alternative options for investors.
Systemic vs non-systemic risk
Systemic risks affect all (or almost all) companies at once. A very good example of this was the global financial crisis of 2008, where the share prices of all companies in the UK (and the USA, Europe and further afield) fell at around the same time. Systemic risks affect the entire financial system (hence the name: systemic risk).
On the other hand, non-systemic risks only affect one company or one industry. This post is particularly timely because in the last week 3 large companies have been affected by different non-systemic risk:
- On 1st August, the share price of AA (the accident recovery firm) fell around 14% after its Chairman was unexpectedly fired for gross misconduct
- On 27th July, the share price of AstraZeneca (the chemical giant) fell around 16% after one of its clinical trials failed
- On 26th July, the share price of Provident Financial (the doorstep lender) fell around 6% after it released its financial results which showed a 45% fall in profits
The FTSE 100 index shows the collective share price changes of the 100 largest companies based in the UK, including AstraZeneca.
On the day the AstraZeneca share price fell by 16% the FTSE 100 index rose by around 0.1%. This shows that AstraZeneca’s bad day did not have a knock on effect with the entire UK share market even though it is a very large firm.
Even the best investment manager in the world couldn’t predict that these events would happen to these 3 companies. This is a perfect example of why we believe investors should steer clear of buying individual shares: it is impossible to know what is round the corner for the company you invest in.
There is one key factor which offers protection against non-systemic risk. This is diversification (or, put simply, the benefit of not having all your eggs in one basket).
For example, if you only held AstraZeneca shares you will undoubtedly have noticed the 16% price plunge on 27th July. On the other hand if you owned some shares in each company in the FTSE 100 index you might not have noticed. This is the benefit of diversification.
Our company does not give advice regarding buying and selling individual shares. Instead we think investing in “funds” is a far better way to access global financial markets. One of the key reasons for this is the way in which funds can offer diversification to individual investors
A fund involves lots of investors pooling their money together. A person (or a team of people) runs the fund and makes investment choices for the investors.
If you have £10,000 available to invest it would be expensive and very time consuming to buy lots (i.e. dozens) of UK shares. It would also be difficult to choose which shares to invest in and which to avoid, plus you would be ignoring the benefits of investing in different assets (such as bonds or property) or investing overseas.
Funds do not experience these problems. This is because they are typically very large – for example, many funds in the UK control around £200 million of their investors’ money (and lots of funds control billions of pounds).
Also, the team in charge of the fund are experts in their field and can easily choose where to invest. This means funds can invest in lots of different types of investments, both in the UK and abroad.
Some funds might hold as few as 10 to 20 individual shares whereas others might hold hundreds of different shares (or bonds, properties and other assets). As the number of holdings increases, an investor’s exposure to non-systemic risk reduces significantly.
This concept is summarised in the following diagram, which demonstrates what happens to an investor’s exposure to non-systemic risk as the number of holdings (e.g. shares, bonds or other assets) in the portfolio increases:
As you can see from the chart, as the number of holdings increases the investor’s exposure to non-systemic risk reduces. You will also notice that, even when the portfolio is diversified, systemic risk still remains. This is because even if you own dozens of different shares around the world you are still exposed to events such as the global financial crisis of 2008.
Systemic risk can be reduced (or even removed entirely) but doing this is more complicated than diversifying your portfolio to remove non-systemic risk. Explaining how to reduce exposure to systemic risk is far beyond the scope of this short post.
If you have money invested in AA, AstraZeneca or Provident Financial shares you have had a pretty rough week. This is an excellent example of the effects of non-systemic risk because each of these companies went through an event which affected their share prices but didn’t affect the share prices of other companies.
Non-systemic risk is a big threat to investors who buy individual shares. From a risk management perspective these investors might be better off if they consider investing in funds instead.
Some people don’t like the idea of selling their shares. This could be because the company they invest in pays a regular dividend, because the share price has done well in recent years or because the investor has an emotional attachment to the shares or the company.
As this post clearly demonstrates, there are potentially significant risks of holding onto shares rather than diversifying your investment portfolio. You never know what might happen next with an individual company, no matter how big it is.
If you are interested in investing for the long term or if you have any questions or concerns about this post, please get in touch with us and book a free initial meeting with one of our investment advisers.
To do this you can visit our Contact us page, email firstname.lastname@example.org or phone 01642 477758.
Please note: our company does not offer advice about buying or selling shares in individual companies. This article should not be construed as a recommendation to buy or sell shares in any company.