Expert Level

Learn advanced topics about trading strategies, risk management and more.

Lesson 8: Systematic Risk

What is Systemic Risk?

Systematic
risk refers to the risk inherent in the entire market or market segment.
Systematic risk, also known as “undiversifiable risk,” “volatility,” or “market
risk,” affects the overall market, not just the inventory or sector. This form
of threat is both unpredictable and impossible to avoid. It cannot be mitigated
by diversification, only through hedging and with the right asset allocation
strategy.

Understanding Systematic Risk

Systematic
risk shall include other investment risks, such as industrial risk. If an
investor places too much focus on cyber security stocks, for example, it is
possible to diversify by investing in a variety of stocks in other industries, such
as healthcare and infrastructure. Systematic risk, however, involves
adjustments in interest rates, unemployment, recessions and conflicts, among
other major changes. Shifts in these areas can affect the entire market and cannot
be mitigated by changing positions within the public equities’ portfolio.

To help
mitigate market risk, investors must ensure that their portfolios include a
variety of asset classes, such as fixed income, cash and real estate, each of
which will react differently in the event of a major systemic change. Increased
interest rates, for example, will make some new-issue bonds more expensive,
while at the same time causing some company stocks to fall in price as
investors think like management teams are cutting back on spending. In the
event of an increase in interest rates, ensuring that a portfolio contains
enough income-generating securities will minimize the loss of value of certain
stocks.

Systemic Risk Vs. Unsystematic Risk

While
systemic risk may be considered to be the probability of loss associated with
the entire market or segment of the market, non-systematic risk refers to the
likelihood of loss within a particular industry or security.

Systemic risk and the Great
Recession

The Great
Recession is also an example of systemic risk. Anyone who was investing in the
market in 2008 saw a dramatic change in the price of their capital as a result
of this economic crisis. The Great Recession impacted asset groups in various
ways, as riskier bonds (e.g. those more leveraged) were sold in large
quantities, while safer assets, such as the US, were sold out. Treasury bonds
have become more expensive.

If you
want to know how much systemic risk a specific security, fund, or portfolio
has, you can look at its beta, which determines how volatile the investment is
relative to the overall market. A beta greater than 1 means that the investment
has more systemic risk than the market, while less than 1 means less systematic
risk than the market. A beta equal to one means that the investment bears the
same statistical risk as the market.

A very specific group of
securities or an individual security is influenced by the opposite of systemic
risk, unsystematic risk. Unsystematic risks can be mitigated by
diversification.