According to Xiaoxia Lou, a finance professor at UD’s Lerner College of Business and Economics, the fragility of the U.S. equity market has increased over the past few decades. But what has caused the fragility of the equity market to increase?
Lou explained that in finance, fragility means the systematic risk of a stock. Systematic risk, she said, affects many stocks in the market, while firm-specific risk is unique to one firm.
While both types of risk can be bad for investors, Lou said that systematic risk is more dangerous because it affects the entire market and can’t be solved with diversifying.
“As an investor, you would probably be more concerned about a systematic risk than a firm-specific risk,” Lou said. “Because [firm-specific risk] can be diversified away if you hold a large portfolio that has many stocks.”
As an example of factors that increase systematic risk, Lou discussed what happens when two or more stocks are correlated (meaning that as one increases in value, the other one will as well).
“Two stocks can be correlated because they are in the same industry, or maybe they are from the same region and subject to the same local economic policies,” Lou said.
But stocks can also correlate just by virtue of the fact that they are part of the same index (owned by the same institution), because they will likely be traded at the same time.
“Because they are owned by the same common investor and being traded together, they are at risk,” Lou said.
When these stocks are correlated and then traded, Lou said, that’s when the market is vulnerable to systematic risk.
“When they are so highly correlated, when you have a liquidity shock, that’s when they sell those stocks at the same time,” Lou said. “That’s going to drive down all of the stocks in their portfolio. That’s why the U. S. stock market is more vulnerable.”
Lou said when it comes to systematic risk, larger firms are more dangerous than smaller firms because larger firms are more likely to be part of an index. This increases the effect of correlation when a large firm owns correlated stocks and trades them.
This risk is also impacted by the recent growth in index funds, Lou said. While this is good for investors in some ways, she explained, “The unintended consequence is that when money goes to index funds, it increases the systematic risk of the market.”