Annuity Training for Systematic Risk, Active Management, and Indexing
Systematic risk is when the value of your investments decreases over a period of time due toeconomic factors and changes in the market that impact your investments. Unsystematic risk onthe other hand, refers to a possible change in price of your investment due to the changing factorsof a specific security, as opposed to the overall economic changes. An
canhelp you reduce systematic risk. Consulting an
can be useful because thesespecialists know how to decrease the risk by diversification or asset allocation. Annuityspecialists go through
where they are taught how to manage and decrease risksfor their clients.
The Handbook of Financial Investments
(2002) by Frank J. Fabozzi: “For commonstocks, several studies suggest that a portfolio size of about 20 randomly selected companies willcompletely eliminate unsystematic risk leaving only systematic risk (
: the first empiricalstudy of this type was by Wayne Wagner and Sheila Lau, “The Effect of Diversification onRisks,”
Financial Analysts Journal
, November-December 1971). In the case of corporate bonds,generally less than 40 corporate issues are needed to eliminate unsystematic risk.”A chart in Fabozzi’s book shows roughly 60% of total risk is 95% eliminated through the (near 100%) elimination of unsystematic risk. This means that an advisor can eliminate close to 60%of a client’s stock market risk by avoiding unsystematic risk.
Active management can be used as a way to reduce risk as well. Active management is a strategythat can be used by an
or manager where the goal is to outperform aninvestment benchmark index by making certain investments. Investors who don’t aspire tooutperform a benchmark index will usually invest in something known as an index fund which isknown as the opposite of active management, passive management. The way an active manageror
will go about trying to surpass the index is to exploit market inefficienciesby buying undervalued securities or by underselling overvalued securities.
A 2009 study by Morningstar concludes: “while about half of actively managed fundsoutperformed their respective Morningstar indexes,
only 37% did on a risk-, size- and style-adjusted basis
. The numbers are similar for five and 10-year returns.” Funds that performed inthe top 25% over the past three years had much lower risk and volatility than their peers.Understanding indexing is also important for managers and is discussed in many
courses. According to financial advisor William Thatcher, indexing tends to beat activemanagement in top-performing asset classes and loses to active management in the worst- performing asset classes. Thatcher believes “in the best-performing asset classes, index funds arerewarded for purity and active managers are punished for their impurity (many do not stay true toa particular investment style).” Results of Thatcher’s study (1998-2007) show that the benefit of indexing was not consistent over one-year periods. The results of the Thatcher study were