Systematic risk refers to the risk inherent to the entire market. Systematic risk, also known as undiversifiable risk, volatility risk, or market risk, affects the overall market, not just a particular stock or industry.
Key Takeaways
- Systematic risk is inherent to the market as a whole, reflecting the impact of economic, geopolitical, and financial factors.
- This type of risk is distinguished from unsystematic risk, which impacts a specific industry or security.
- Systematic risk is largely unpredictable and generally viewed as being difficult to avoid.
- Investors can somewhat mitigate the impact of systematic risk by building a diversified portfolio.
Understanding Systematic Risk
Systematic risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.
Systematic risk underlies other investment risks, such as industry risk. For example, if an investor has placed too much emphasis on cybersecurity stocks, it is possible to diversify by investing in a range of stocks in other sectors, such as healthcare and infrastructure.
However, systematic risk incorporates interest rate changes, inflation, recessions, and wars, among other major changes.Shifts in these domains can affect the entire market and cannot be mitigated by changing positions within a portfolio of public equities.
To help manage systematic risk, investors shouldensure 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 systematic change. An increase in interest rates, for example, will make some new-issue bonds more valuable while causing some company stocks to decrease in price as investors perceive executive teams to be cutting back on spending. In the event of an interest rate rise, ensuring that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities.
Systematic Risk vs. Unsystematic Risk
The opposite of systematic risk is unsystematic risk, which affects a very specific group of securities or an individual security. Unsystematic risk can be mitigated through diversification. While systematic risk can be thought of as the probability of a loss that is associated with the entire market or a segment thereof, unsystematic risk refers to the probability of a loss within a specific industry or security.
If you want to know how much systematic risk a particular security, fund, or portfolio has, you can look at its beta, which measures how volatile that investment is compared to the overall market. A beta of greater than one means the investment has more systematic risk (i.e., higher volatility) than the market, while less than one means less systematic risk (i.e., lower volatility) than the market. A beta equal to one means the investment carries the same systematic risk as the market.
Systematic risk is different from systemic risk, which is the risk that a specific event can cause a major shock to the system.
Systematic Risk Example
The Great Recession also provides an example of systematic risk. Anyone who was invested in the market in 2008 saw the values of their investments change drastically due to this economic event. The Great Recession affected asset classes in different ways, as riskier securities (e.g., those that were more leveraged) were sold off in large quantities, while simpler assets, such as U.S. Treasury bonds, became more valuable.
What is Unsystematic Risk?
The opposite of systematic risk is unsystematic risk, which affects a very specific group of securities or an individual security. Unsystematic risk can be mitigated through diversification. While systematic risk can be thought of as the probability of a loss that is associated with the entire market or a segment thereof, unsystematic risk refers to the probability of a loss within a specific industry or security.
How Can an Investor Manage Systematic Risk?
While systematic risk is both unpredictable and impossible to completely avoid, investors can manage it by ensuring that their portfolios include a variety of asset classes, such as fixed income, cash, and real estate, each of which will react differently to an event that affects the overall market.For example, an increase in interest rates will make some new-issue bonds more valuable, while causing some company stocks to decrease in value. Making sure that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities.
What’s the Relationship Between Beta and Systematic Risk?
An investor can identify the systematic risk of a particular security, fund, or portfolio by looking at its beta. Beta measures how volatile that investment is compared to the overall market. A beta of greater than one means the investment has more systematic risk than the market, while less than one means less systematic risk than the market. A beta equal to one means the investment carries the same systematic risk as the market.
The Bottom Line
Systematic risk refers to the risks inherent in an entire market or economy rather than being specific to a particular company or industry—known as inherent risks. Systematic risk is also known as market risk or undiversifiable risk and can arise from factors such as inflation, recessions, war, changes in interest rates, fluctuations in currency exchange rates, natural disasters, and other macroeconomic events that impact the market as a whole.
Systematic risk can be mitigated through diversification, but the risk would still affect all investments in a particular market or economy. As a result, investors must be aware of the potential for systematic risk when making investment decisions and take steps to manage this risk through strategies such as asset allocation and risk management.
