28 Jan Wuhan Coronavirus Risk

The Wuhan Coronavirus Risk

There are two categories of risk investors face when owing stocks: Systematic risk and Idiosyncratic risk. Neither are the kind of thing you would bring up for dinner party conversation, but they are important to understand as they have implications for your portfolio

When your portfolio is sitting in cash, you can basically assume you have no risk (this isn’t true. You actually run significant risk in the low interest rate environment, but we will address this another time). When you spend that cash on stocks you are taking on risk. Taking on risk is what gives the opportunity for profit. Without risk, there can be no profit reward

Your role as an investor then is to manage the risk inherent in owning stocks. Profits will take care of themselves if you correctly manage your risks.

Systematic risk is market risk. Think of it as an event that effects all stocks in the market at the same time. The Wuhan coronavirus has the potential to be a systematic risk if it continues to spread.

Right now, the coronavirus is an idiosyncratic risk for some US companies. We’re seeing this risk being priced into travel-related stocks and some casino stocks. United Airlines (UAL) is one such stock. Last week, O’Hare International Airport began screening passengers from China. The virus could become a problem for UAL as an idiosyncratic risk.

Were the virus to continue spreading, it could become a systematic risk to all stocks in general. This would be the case if the health threat became big enough to potentially have broader economic ramifications.

We are not virologists. Even if we were, we wouldn’t be able to predict the odds of the Wuhan coronavirus causing a significant problem for the S&P500 as a systematic risk.

I remember trading back in 2003 when the SARS virus broke out. At that time the Chinese government were criticised for not doing enough to prevent the spread of the disease. SARS went on to kill 770 people, mostly in Asia. In the peak 4 months of that virus the S&P500 fell 8.3%. But after that, when the news went away, the S&P500 put on 18.6%.

The point here is we have nothing to worry about yet. Whilst the market is doing its usual sell on initial news, it is more of an opportunity than a concern at present.

The best way you can defend against idiosyncratic risk is through diversification of holdings in your portfolio. That is why we encourage you to hold several stocks in your portfolio. The best way to defend against systematic risk is to have an investment plan that does not rely on short term market movements.

The Capital 19 Model Portfolios are designed to give you ideas about how to diversify your portfolio. Check them out here if you haven’t already

Any single stock can rise and fall. Over the long term, a diversified portfolio of stocks with favourable characteristics will both increase in value and compensate your for the systematic and idiosyncratic risks taken.