Rationally Facing Investment Risks

Systematic risk affects the entire market, while unsystematic risk is specific to individual investments. Should focus on actual risk rather than perceived risk, be cautious at market peaks, and prioritize minimizing losses in bear markets over maximizing gains in bull markets to achieve long-term outperformance.

Systematic and Unsystematic Risks

Systematic risk affects the entire market, while unsystematic risk is specific to individual investments. Diversification can mitigate unsystematic risk but not systematic risk. Investors must understand and manage both types of risk to navigate the market effectively.

Unsystematic Risk

Unsystematic or diversifiable risk is caused by events occurring in individual companies. For example, poor financial reports, labor disputes leading to strikes, the chairman’s embezzlement and escape, factory fires, etc., all belong to the risks faced by individual stocks and, therefore, are called diversifiable risks.

It is called diversifiable because investors can spread the risk of individual stocks evenly across the portfolio by purchasing Exchange-Traded Funds (ETFs) or mutual funds. In addition, the risk of capital costs can also be reduced by purchasing ETFs or funds.

Therefore, these types of risks can be diversified through strategies and belong to unsystematic risks.

Systematic Risk

Another type of risk is caused by external factors called systematic risk. Simply put, it is the risk of a stock market crash. Many factors affect a market crash, such as wars, economic cycles, energy crises, government policy adjustments, etc. Taking the Shanghai Stock Exchange as an example, its stock market is very susceptible to fluctuations due to changes in national policies.

Facing this type of risk, hardly any assets can diversify it. Even bonds, the only assets that can produce some substitution effect in the early stages of a stock market crash, may also directly decline.

Therefore, in asset allocation, a cyclical investment approach must be adopted. When systematic risk is very high, little capital should be invested. This is why it is necessary to deploy funds when the base is low, and the economy is sluggish. The probability of systematic risk occurring is relatively low, and stocks are cheap enough.

However, the timing of systematic risk occurrence is usually difficult to predict, and it is only known that the probability is higher when the base is high. Although systematic risk is difficult to avoid completely, investors can reduce the overall risk of the investment portfolio by diversifying investments in different asset classes (stocks, bonds, commodities, real estate, etc.).

Black Swan Event

Black swan events have three characteristics:

1. Rarity: It is a surprise(exceeded expectations).
2. Extreme Impact: It will significantly affect the fluctuations of assets.
3. Retrospective predictability: Looking back, the event could have been expected to take place.

For example, the stock market crash in March 2020 was a black swan event caused by the COVID-19 pandemic. When investors encounter a black swan event, accumulated profits may be lost overnight. Therefore, it is necessary to have antifragility in order to face black swan events.

Perceived and Actual Risks

From a psychological perspective, risk can be divided into perceived and actual risks. When stocks soar, the actual risk rises, but the perceived risk decreases. This is because any news is regarded as positive in a bull market. At this time, although the base is already very high and the actual risk is very high, investors feel that the risk is decreasing and believe that the stock market will continue to rise.

Conversely, when stocks plummet, the actual risk decreases because the base is lowered, but the perceived risk rises due to the pessimistic sentiment in the market.

Investors should focus on actual risk. When the actual risk decreases, such as when the stock market plummets and the base is lowered, it is time to invest funds.

Example: Airplanes and Cars

Taking airplanes and cars as an example, for the same distance, the accident rate of taking airplanes is much lower than that of taking cars. However, more people are afraid of taking airplanes than those who fear taking cars. This is because the perceived risk of taking airplanes is greater, but the actual risk is very small.

For example, many people are afraid to take airplanes after an airplane incident. However, after each airplane incident, the safety control of airplanes becomes stricter, and the actual risk decreases. However, most people’s perceived risk rises, and they fear flying.

Example: The Heartbroken Person and the Old Monk

There is a story about a heartbroken person who told an old monk about the trouble of being unable to let go of something. The old monk asked him to hold a glass and pour hot water. When the glass began to burn his hand, the person put the glass down. The old monk said, “This matter is like this cup of tea. When it hurts, you let it go.”

Many people are like this when investing in stocks. When stocks rise, and they feel happy, they go all-in. When stocks fall, and they feel pain, they clear their positions, always buying at the highest point and selling at the lowest point.

Bull Market and Bear Market Risks

After understanding the investment strategy and operation methods of cyclical investing, there is still a question: as a long-term investor in cyclical investing, is one attempting to estimate the peak? Cyclical investors are particularly cautious at the peak because of an important concept: not losing money in a bear market is even more crucial than making money in a bull market.

For many long-term investors who outperform the market, beating the market in a bull market is not particularly important. Compared to achieving excess returns in a bull market, as long as one can lose a little less than the market in a bear market, the rate of return can completely surpass the entire market.

Mathematical Formula

Investment Scenario	Year 1	Year 2	Performance
Index Investor	-20%	+40%	12%
Aggressive Investor	-40%	+80%	8%
Conservative Investor	0%	+20%	20%

In three different investment scenarios, the return differences for investors in a bull and bear market cycle:

1. Index Investor Performance: (1-0.2) × (1+0.4) – 1 = 0.12 = 12%
2. Aggressive Investor Performance: (1-0.4) × (1+0.8) – 1 = 0.08 = 8%
3. Conservative Investor Performance: (1+0) × (1+0.2) – 1 = 0.2 = 20%

Over the entire cycle, the Index Investor is 12%. Assuming the aggressive investor amplifies profits and losses by a factor of two, although they earn more in the bull market, the final return is only 8%, underperforming. By effectively controlling losses, the conservative investor, despite underperforming the Index Investor in the bull market, still achieves a 20% return, significantly outperforming the Index Investor.

Not Losing Money in a Bear Market is More Important than Making Money in a Bull Market

A simple mathematical formula reveals a truth: investors who want to outperform the market in the long run do not need to beat the market during a bull market. As long as they ensure their losses are less than the market during a bear market, even if they cannot keep up with the market during a bull market, they still have the opportunity to achieve excess returns.

This simple calculation often contradicts people’s intuitive feelings. Many investors believe that losing more in a bear market doesn’t matter if they can earn it back in a bull market. As a result, many people make a lot of money in a bull market, even catching big bullish stocks that rise much more than the market. However, they lose too much in a bear market because the assets they buy do not have fundamental support or do not understand the logic of the entire economic cycle. Ultimately, their performance underperforms the market when calculated over the long term.

Therefore, the primary principle for cyclical investors at the peak is it is better to earn a little less than to lose money in a sudden bear market. At the same time, investors should further value diversification, asset allocation, and other risk management strategies to reduce the investment portfolio’s overall risk.

Conclusion

After fully grasping the concepts of systematic risk, unsystematic risk, perceived risk, actual risk, bull market risk, and bear market risk, it becomes clear that when it comes to unsystematic risk, it is crucial to enter the market in batches as much as possible, which can be done by purchasing ETFs or mutual funds. Regarding systematic risk, it is essential to learn how to reduce one’s stock position as much as possible during high base periods so that ample funds will be available to enter the market during low base periods when the stock market undergoes a correction.

The most painful moments for investors are when they should not let go. As Warren Buffett, the renowned American investment guru, famously said, “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”