What is Systematic Risk and How can an Investor Control?

Systematic risk refers to the inherent uncertainty that is present in all investments and is not specific to any particular company or industry. It is caused by external factors that affect the entire market and cannot be diversified away. Examples of systematic risk include economic recessions, natural disasters, and changes in government policies.

Types of Systematic Risk

Here are some of the types of systematic risk:

1. Interest Rate Risk

We are aware that central banks, like the Federal Reserve, occasionally change their policy rates in an effort to expand or contract the amount of money in the economy. The economy’s interest rates are impacted by this. 

When the central bank lowers interest rates, the money supply rises, businesses start borrowing more, and they start to grow. The converse is true when the policy rate is raised. This cannot be diversified because it is influenced by the business cycle.

2. Risk of Inflation

When inflation exceeds the targeted level, less money has the same purchasing power. Because spending and consumption decline, which in turn causes a decline in investments, this lower returns across the board for the market.

3. Exchange Rate Risk

If the value of the currency relative to other currencies declines, so do the profits on investments made in that currency. In such circumstances, all businesses that use that currency for transactions suffer losses, which causes investors to suffer as well.

4. Geopolitical Risks

If a nation has serious geopolitical difficulties, all of the nation’s businesses suffer. This can be diversified by making investments in many nations, but if foreign investment is prohibited in a nation and domestic security threats are present, the entire market for investable securities will suffer losses.

5. Natural Catastrophe

All businesses in nations like Japan that are vulnerable to earthquakes or volcanic eruptions must contend with this issue. This can be diversified by not investing in Japan, but many investors do not find it to be a satisfactory answer.

The overall propensity of investors to act in accordance with the market leads to market risk. For instance, during a financial crisis, investors stay away from even the best-performing enterprises. In most cases, market risk makes up around two-thirds of all systematic risk.

Impact of Systematic Risk

The magnitude of beta can be used to determine the extent to which systematic risk has an impact on a stock’s return relative to market returns:

• When β = 1, systematic risk has an equal impact on market and stock returns.
• When β = 0, systematic risk has no impact on stock returns but does have an impact on the market.
• When β < 1 systematic risk affects stock returns, it does so to a lesser extent than when it affects the market.
• When β > 1, systematic risk has a greater impact on stock returns than it does on the market.

Asset allocation is the answer to systematic risk. Some of the portfolios should be invested in a different market if a certain systematic risk affects one market. Although the market is currently defined as being dynamic, we can define it here as including several asset classes.

By examining the beta of a given security, fund, or portfolio, an investor can determine the systematic risk involved. The investment’s beta compares its volatility to the market as a whole. If the investment’s beta is larger than 1, it has a higher systematic risk than the market, whereas a beta of less than 1 has a lower systematic risk than the market. The investment has the same systematic risk as the market if its beta is equal to one.

Also Read

What is Risk Averse And How To Measure Risk Averse?

What Is Risk-to-Reward Ratio: Its Calculation, Formula And Importance

How Can an Investor Control Systematic Risk?

Investors can manage systematic risk by making sure that their portfolios contain a variety of asset classes, such as fixed income, cash, and real estate, as each of these will respond differently to an event that affects the overall market. 

Systematic risk is unpredictable and impossible to completely avoid, but investors can manage it by making sure that their portfolios contain these asset classes. For instance, a rise in interest rates will boost the value of some newly issued bonds while depreciating the value of some firm stocks. Ensuring that a portfolio has a sufficient number of income-producing securities will help to reduce the value loss in particular stocks.

Investors should make sure their portfolios comprise a variety of asset types, including cash, real estate, and fixed income, as each of these will respond differently in the case of a severe systemic change, in order to manage systematic risk efficiently. 

Advantages and Disadvantages of Systematic Risk

Let’s talk about the advantages of systematic risk first:

1. A Holistic Perspective

As a result of taking into account the entire economy, the analyst would have a clearer understanding of the situation. Instead of needing to determine the risk present in each sector separately, it would act as a proxy for the risk of the overall economy. 

2. Understanding Non-Diversifiable Risk is Facilitated

The investor would typically be able to determine the amount to which his portfolio was exposed to non-diversifiable risk by comprehending the systematic risk that would have an impact on the economy. As a result of the impact of any such occurrence that would affect the market as a whole, they would also have a solid sense of or understanding of the volatility that it would cause in the portfolio. 

3. Aids in the Identification of Risk

The foundation of both insurance and investment is risk diversification. But the existence of systematic risk has an impact on everything simultaneously. This approach helps to better understand and detect risks by using a probabilistic approach to analyze its impact on the risk profiling of the insurance firms’ portfolios. Diversification does help in recognizing and identifying hazards, even though systematic risk cannot be decreased by it.

However, there are quite a few drawbacks of systematic risk.

1. Mass Effect

These hazards affect everyone, in contrast to dangers that are sector-specific. For instance, firms might experience a slowdown, a decline in capital inflow, and job losses. Therefore, such risks have an impact on the entire economy and could trigger a worldwide slowdown if the negative effects extend to other nations. 

2. Studying Sector-Specific Risk is Difficult

It takes into account the entire economy. It would be challenging to evaluate the effects on different industries, stocks, and companies separately. These businesses may be impacted by sector-specific risks and variables. It is crucial to study them separately rather than taking a comprehensive approach in order to properly comprehend them. 

3. The Magnitude of the Impact could Vary

The non-diversifiable risk affects the entire economy on a systematic level, although its severity can vary depending on the industry and sector. Here, it is crucial to comprehend and research these sectors from a perspective distinct from that of the broader economy.

What are Unsystematic Risks?

Unsystematic risks are risks that are peculiar to a company or industry. They are also referred to as non-systematic risks, specific risks, diversifiable risks, or residual risks. These risks are brought on by a variety of internal or external variables that solely affect the specific business in question and not the entire market.

Unrest among factory workers, changes in regulations, and a lack of raw materials are a few instances of unsystematic risk. Unsystematic risks, as opposed to systematic risks, can be managed, reduced, or even completely avoided by an organization.

Difference Between Systematic Risk and Unsystematic Risk

Refer to the table below to understand the difference between systematic and unsystematic risk

Final Word

Like unsystematic risks, systematic risks cannot be mitigated or eradicated, but there are techniques to successfully safeguard your company from their effects. Unfortunately, quantifying total risk and volatility and devising management strategies can be quite difficult, especially for traders or investors with limited portfolios.

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