Unsystematic Risk

Anna knows more about systematic risk of winfit, also called general market risk. However, she wants to understand both risks before buying winfits stocks. Hence, she is wondering about the meaning of winfits unsystematic risk.

Unsystematic risk describes an industry or company specific risk that is part of each investment. This risk concerns a specific company and is therefore also called “specific or risidual risk”.

In contrast to systematic risk, diversification (buying different assets in different industries) can reduce unsystematic risk.

A unsystematic risk for winfit is the increase of the price for cotton, since most of their sports clothes are made out of this material. If the cotton price increases, winfits profit margin decreases. In order to minimize this risk, Anna could also buy commodities (like cotton).

This diversification reduces the unsystematic risk, but not the systematic risk. While looking at the overall risk of an investment, the major parts are specific, unsystematic risks while a smaller portion includes the systematic risk.

Typical examples for unsystematic risk include new competitors, new law regulations or the price increase of raw materials.   

Systematic Risk

As you know from this article, Anna loves sports. Meanwhile, she did some market research and finally decided to buy 3 stocks of winfit. Winfit is a publicly listed company which sells all kind of sports equipment. Anna’s winfit favourite is the wearable smartwatch with an heart rate tracker. If you wonder why companies are publicly listed, check out this article.   

While Anna did her research, she stumbled upon the terms systematic risk and found the following definition:

Systematic Risk is the general market risk. This systematic risk concerns the entire market and since it can’t be reduced by buying different stocks, this risk is also called “non-diversifiable risk”.

Everyone who invests in the market, assumes this general market risk. Systematic risk is caused by events, that influence the entire market such as wars, major political decisions or natural disasters. In the week after hurricane Irma hit Florida, the S&P 500 fell almost 2%. S&P 500 represents 500 large companies that are listed on the American Stock markets.

Anna asked herself “Does winfit really have the same systematic market risk as any other company? For example when Irma hits Florida, winfit might not be affected as much as insurance companies?”

And Anna was right. Only very few companies have the exact same systematic risk as the market does.

Beta measures the amount of systematic risk in an investment. It’s a measure for correlation between investment and market.

A Beta > 1 means that an investment has more systematic risk than the market.

A Beta < 1 means that an investment has less systematic risk than the market.

A Beta = 0 means that an investment has the same systematic risk as the market.

As previously mentioned, the term market refers to indices like S&P 500, DAX or Russell 2000. Continue reading, if you’d like to learn more about unsystematic risk.

Investment #7 – Call Options

Katie loves Este Lauder (EL) products and thinks that the price of EL shares will go up. Marissa currently owns EL shares, but thinks that the price will either stay the same or go down in the future. The girls talk, and decide to write up a call option.

Call Option

An agreement that gives an investor the right, but not the obligation, to buy an asset at a specified price within a specific time period.

Right now, each EL share is priced at 10$. Marissa writes up a call option agreeing to give Katie 100 shares of EL at 12$ per share in a month. The fee that Katie pays for the option (aka premium), is 200$ (the 2$ per stock difference times 100 shares).

If the price of EL shares shoots up to 15$ in a month, Katie can exercise the option and buy Marissa’s 100 shares of EL at only 12$. Since Katie is getting the shares for 3$ less than the actual price, she makes $300 (3$ x 100 shares) minus the initial fee of $200, resulting in a net profit of $100.

If the price of EL shares go down to 8$, Katie will not chose to exercise the option (she won’t buy the 100 shares), and will simply loses the $200 initial fee she paid at the start.

Call options allow individuals to speculate about stocks that they do not own. If you believe a certain company or asset will go up in the future, you might want to consider a call option!

Investment #6 – Futures Contracts

Lily is the owner of a coffee shop. Every month, Lily buys raw coffee beans from Emma’s farm for 2$ per bag. Both girls are happy with this price, and decide to write up a futures contracts to protect themselves from price changes.

 

Futures Contract

A contract for assets (especially commodities or shares) bought at agreed prices but delivered and paid for later.

 

To sign a futures contract, both Lily and Emma meet with an investor separately, and the investor handles the transaction. Lily signs a contract stating that she will purchase the coffee at 2$/bag in the future, and Emma signs a contract stating that she will sell her coffee at 2$/bag in the future. Any changes in price will be dealt by the investor.

These contracts protect both Lily and Emma from the risk of volatile price changes:

For example, if the coffee market becomes more competitive, the price of coffee will drop, and Emma will be forced to sell her coffee bags at a cheaper rate thus losing money.

On the other hand, if poor weather affects the coffee crops, the price of coffee will increase, and Lily will have to pay more for her bags of coffee.

Thus, by having a future contract in place, the “risk of the unknown” goes away, and both girls know exactly what to expect in the future. They can continue their business operations without worry.

So what does the investor have to do with all this?

Well, if the price of coffee goes under 2$ per bag, the investor promises to pay Emma the difference so that she doesn’t lose any money. However, if the price goes over 2$ per bag, the investor gets to keep the extra profits from Emma’s sales.

On the other hand, if the price goes down, Lily will still pay the investor 2$ per bag and the investor will profit from the difference. If the price goes up, the investor will cover the difference and Lily will still pay only 2$.

Of course, there is potential for an upside or downside for both Lily, Emma and the investor when signing a futures contract. However, both girls get to benefit from ditching the “risk of the unknown”.

Investment #5 – Real Estate

Allison just made $83,000 from a $20,000 investment. Ten years ago, she had bought an apartment as a real estate investment.

Real Estate Investment

Properties that generate income for a buyer and that are bought to make money, not to live in.

When Allison bought the house 10 years ago, she planned to rent it out and then eventually resell it for more than she had bought it. This way, she would make money from the monthly rent payments, and the increase in property value.

So how exactly did she make $83,000 from only $20,000 with this investment? Here’s how:  

Allison bought the house for $100,000 using $20,000 of her own money and $80,000 that she borrowed from the bank at a 3% annual interest rate. This means that until Allison paid back the $80,000 loan to the bank, she’d have to give them $3,000 per year or $200 per month.

But that was easy, because by renting out the apartment, she received $1,000 per month – enough to pay the bank $200 and enough to keep $800 to herself. She continued to do this for 10 years, until she saved up $96,000 to herself ($800 x 12 x 10)!

During this time, the value of the apartment had also gone up from $100,000 to $120,000. She sold the apartment, and ended up with $120,000 + $96,000 = $216,000! Of course, Allison had to pay back the $80,000 she had borrowed from the bank. Also, since she made profit from this investment, she had to pay taxes of $33,000, leaving her with $103,000. After removing the initial $20,000 that Allison had invested of her own money, Allison has made a $83,000 profit from this investment… wow!

Of course, as a property owner, Allison was responsible for maintenance, finding tenants, collecting rent, etc. So there are other difficulties and expenses to consider. Also, the house market can go up or down. So, the risk of the apartment decreasing in value was also possible. Luckily for Allison, everything went as planned and she was able to make a lot of money from this investment.

Investing in real estate is one of the most popular types of investments, as it can provide you with huge returns! But like every investment, there are always risks to consider.

Would you invest in real estate? Let us know in the comments below!

Difference Between Mutual Funds & ETFs

As seen in our previous articles, we learnt that Mutual Funds and ETFs are like very similar cousins. They are both a collective investment – a pool of money from a bunch of different investors that purchases and invests in a variety of securities.

So what are the main differences between the two? Find out below:

Mutual Funds

ETFs

1. Price is set once a day

2. Actively managed by an expert

3. Less research needed from you

4. Purchased from a broker, advisor or fund

5. Higher fees

1. Traded all day – price constantly changing

2. Managed by yourself

3. More research needed from you

4. Purchased on the stock market

5. Lower fees

It’s totally up to you to decide which one you prefer. Up until now, Mutual Funds have been more popular. Today, there are about 13 trillion dollars invested in Mutual Funds compared to 2 trillion in ETFs. However, ETFs are growing in popularity.

Which one would you invest in? Let us know in the comments below!

Investment #4 – ETFs

Victoria is an environmentalist, and is really interested in the green energy sector. Because of increasing Global Warming and other research, she believes the green energy sector will grow a lot over the next decade.

Victoria is interested in investing the little money she has in one of her favourite green companies. But the problem is… there are just too many to choose from! So, Victoria decides to invest in a green energy ETF.

ETF (exchange traded fund)

An investment fund that trades on the stock market. Just like mutual funds, it is a pool of money from different investors that purchases and invests in a variety of securities.

Just like mutual funds, ETFs invests the fund’s money into different securities (stocks, bonds, etc.), providing investors with diversification. In addition, ETFs are traded on the stock exchange, making them very easy to buy and sell.

So why would Victoria chose to invest in an ETF over other alternatives? Well, there are a variety of ETFs to choose from; some ETFs invest in stocks & bonds, some replicate the performance of an entire stock market (stock index), and others replicate the performance of a specific industry sector… In Victoria’s case, she can invest in a Green Energy ETF, which replicates the performance of all of her favourite green energy companies put together.

Overall, Victoria likes ETFs because:

  • It’s an easy way to get a diversified portfolio (less risky)
  • It’s easy to buy and sell on the stock market
  • It allows her to invest in a wide variety of investments
  • There are no management fees and very low transaction fees  

So how will this let Victoria to grow her money? When the fund’s assets (stocks, bonds, etc.) rise in value, so does the value of her ETF shares. In this case, she can sell her shares at a profit. The ETF also pays out dividends to Victoria, which is a portion of the fund’s earnings.

Of course, if the fund’s assets go down in value, so does the value of the ETF shares. Therefore, Victoria makes sure to do research in advance to ensure that the fund’s securities (companies) are good ones!

 

Which industry would you invest your money in?

Investment #3 – Mutual Funds

Every Monday night, Mila and her girl friends get together to watch the Bachelorette. Before the show starts, Mila asks her friends for investing advice. She’s new to investing and wants to start, but she doesn’t have the time to spend hours doing research on her own. Her friend Alexa suggests she checks out mutual funds.

Mutual Funds

A collective investment – a pool of money from a bunch of different investors that purchases and invests in a variety of securities.

Alexa explains that her and the other girls are all currently investing their money in the Super Sexy Finance Fund (SSFF). Here, all of their money is pooled together, and managed by an expert from the Super Sexy Bank. The expert from the Super Sexy Bank takes the money from the fund, and invests it in a bunch of different securities (stocks, bonds, etc.). This is known as the portfolio.

Portfolio:

A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents,

This expert constantly manages the portfolio, buying and selling different stocks and bonds overtime, while the girls sit back and relax. If Mila decides to buy a share in the SSFF, she’ll have a small stake of all investments included in the fund. This is great because it allows Mila to invest in a diversified portfolio, without having to spend a bunch of time doing her own research.

The girls love this type of investment for 3 main reasons:

  1. It’s a simple way to have a diversified investment (less risky)
  2. It’s managed by an expert, therefore saving you time
  3. It allows each girl to invest in a wide variety of investments

So…how do the girls make money? Mila asks.

Well, it’s simple. When the fund’s assets (stocks & bonds) rise in value, so does the value of the SSFF shares. This way, the girls can sell their shares at a profit. The SSFF fund also gives out dividends, which is a portion of the fund’s earnings.

Of course, if the fund’s assets go down in value, so does the value of the SSFF shares. So it’s important to make sure your expert knows what their doing!  It is also important to note that when buying an SSFF share, Mila will have to pay management fees & transactions fees to the Super Sexy Bank expert for his services.

As Mila is looking to invest without spending too much of her own time doing research, this is a perfect investment option for her!

 

What do you think? Is this a type of investment you would like to make?

Investment #2 – Bonds

With Fashion Week around the corner, the city of New York is thinking of opening a new high-end mall to feature all of the new designers and their clothing lines. In order to build the mall, the city of New York needs to borrow money. But instead of borrowing money from the bank, it decides to borrow money from the public, with the issuance of “bonds”.

Bonds:

A loan given to a company or government from an investor (like you).

So why would someone like you give money to the city of New York to build a mall? What do you get out of it? A lot actually. When you decide to lend money to the city of New York, the city of New York will pay you an annual interest rate as a “thank you” for lending them the money in the first place. Once the mall is built, they will give you back your initial payment in full.

For example, the city of New York is offering bonds priced at $1,000 over a 10-year period in exchange for 5% annual interest rate.

So, after paying $1,000 for a bond, you will receive $50 every year for 10 years. Once the 10 years is up, you will get your $1,000 back. Therefore, you made $500 profit from investing $1,000… Not bad right!

The par value (initial price) of your bond is 1000$ with a coupon rate of 5% (yearly interest rate) and a 10 year maturity date.

Buying a bond is a smart way to preserve your money while letting it grow on its own! Bonds are also viewed as safer investing options compared to stocks, since you know exactly how much to expect. Of course, like any investment, bonds still have risk. The risk is much lower than other alternatives, but there is always a possibility that the company or government goes bankrupt and can’t pay back the initial payment (aka default risk).

Usually, institutions with higher default risk provide higher interest rates per year (like corporations) while safer companies provide lower interest rates per year (like governments).

All in all, if you’re looking for a safe investment with stable returns, you might want to consider investing in a secure bond. It’s a great way to preserve your money while letting it grow in your sleep!

Would you invest in a bond? Let us know below!