Systematic Risk

Systematic risk, also known as aggregate risk or undiversifiable risk in economics, pertains to the exposure to events that impact overall outcomes, such as broad market returns, total economy-wide resource holdings, or aggregate income.
Systematic Risk
3 min
01-July-2024

Systematic risk represents the portion of total risk that arises from external factors affecting the entire market rather than issues specific to a particular company. This type of risk commonly represents challenges such as economic conditions, political changes, and social developments. Let’s understand systematic risk’s meaning in detail and explore its various types, causes, and calculations.

What is systematic risk?

Systematic risk is also known as market risk or undiversifiable risk. It represents the several inherent factors that affect the entire market instead of a particular business organisation.

It is essential to note that systematic risk cannot be eliminated through diversification. That’s because it affects many different investments or companies at the same time. For example:

  • Assume that there is an economic recession.
  • This event will cause the stock prices of numerous companies across various industries to drop.

One way to understand and measure systematic risk is by looking at how sensitive a particular security's return is in relation to the overall market's return. For example, if a stock tends to move up or down in sync with market trends, it indicates a high level of systematic risk.

High-return mutual fund categories for smart investing

Equity Mutual Funds Hybrid Mutual Funds Debt Mutual Funds
Tax Saving Mutual Funds NFO Mutual Funds Multi Cap Mutual Funds


Example of systematic risk

A classic example of systematic risk is the economic impact of the COVID-19 pandemic in 2020. The pandemic (external factor) caused a significant economic slowdown and affected the overall market and economy rather than just specific companies or sectors.

Furthermore, it led to:

  • Stock market decline
    • The indices, such as the BSE Sensex and NSE Nifty 50, experienced substantial drops.
    • The investor sentiment turned negative due to uncertainty and fear about the economic outlook.
  • Reduced economic activity
    • Nationwide lockdowns and restrictions led to reduced consumer spending.
    • It halted manufacturing and disrupted supply chains.
    • The effect was felt by companies across various industries.

Key takeaways

  • Systematic risk is a type of risk that affects the entire market.
  • Unlike systematic risk, which affects the whole market, unsystematic risk is the type of risk that affects only particular industries or individual companies.
  • Systematic risk is difficult to predict because it originates from large-scale events that cannot be controlled or easily foreseen.

While you cannot completely eliminate systematic risk, you can somewhat lessen its impact by establishing a diversified portfolio.

Also Read: What is a Risk Profile

Types of systematic risk

We can divide systematic risk into several categories. By understanding these types, you can recognise the sources of market-wide impacts and better manage your investment strategies accordingly. Let’s look at some major types of systematic risk:

Market risk

Market risk refers to the risk of sustaining losses due to the:

  • “Herd mentality” of the investors
    and
  • Factors that affect the overall performance of financial markets

Mostly, it includes changes in the prices of securities due to:

  • Economic events
  • Investor sentiment, or
  • Global crises

For example:

  • Say the stock market crashed due to an economic downturn.
  • This event panicked investors, who rushed to square off their position.
  • Due to this herd mentality, there are widespread losses across various sectors and assets.

Interest rate risk

Interest rate risk is the risk that changes in interest rates will negatively impact the value of investments. This is particularly relevant for fixed-income securities like bonds. Generally, when interest rates rise, the value of existing bonds falls. This happens because new bonds are issued with higher yields, making the older ones less attractive. On the other hand, when interest rates fall, the value of existing bonds usually increases.

Furthermore, it is pertinent to note that interest rate fluctuations can also affect stocks. This holds especially true for companies with significant borrowing costs.

Purchasing power Risk (or Inflation risk)

Purchasing power risk, also known as inflation risk, refers to the likelihood that the value of money will decline over time due to rising prices for goods and services. This erodes purchasing power, which means that the same amount of money buys fewer goods and services in the future. Inflation risk affects all types of investments, but it is particularly concerning for:

  • Cash holdings
    and
  • Fixed-income investments

That’s because the returns from these assets usually do not keep pace with inflation, leading to a real loss in value.

Exchange rate risk

Exchange rate risk, also known as currency risk, arises from changes in the value of one currency relative to another. This type of risk is significant for investors who:

  • Have investments in foreign assets
    or
  • Conduct business in multiple currencies

For example:

  • Assume an Indian investor holds assets in the United States.
  • A depreciation of the US dollar against the Indian Rupee would reduce the value of those investments when converted back to rupees.

It is noteworthy that exchange rate fluctuations significantly impact the returns on international investments and global business operations.

Also read about: What is Mutual Funds Riskometer

How to calculate systematic risk (β)?

Systematic risk is often measured by the beta coefficient in the Capital Asset Pricing Model (CAPM). The beta coefficient indicates the sensitivity of a stock or portfolio to movements in the overall market. Most investors study it in three different forms:

  • A beta of 1 implies that the asset moves in line with the market.
  • A beta of greater than 1 indicates higher volatility than the market.
  • A beta of less than 1 indicates lower volatility.

Causes of systematic risk

Systematic risk arises from broad factors that impact the entire market. Often, these risks are beyond the control of individual companies and are inherent to the market as a whole.

Let us look at some major causes of systematic risk:

  • Economic factors
    • Economic slowdowns or recessions lead to widespread declines in asset prices and overall market performance.
    • Actions by central banks, such as raising or lowering interest rates, impact the entire market.
    • Rising inflation reduces purchasing power and leads to higher costs for all businesses.
  • Political factors
    • Changes in government policies, such as tax laws and trade tariffs, significantly impact the market.
    • Wars, political instability, and international conflicts create uncertainty and disrupt markets globally.
    • New regulations or changes in existing regulations affect entire industries and, consequently, the overall market.
  • Social and environmental factors
    • Health crises, such as the COVID-19 pandemic, create widespread economic disruptions and affect all sectors of the market.
    • Changes in population dynamics, such as ageing populations or shifts in consumer behaviour, influence market trends and economic growth.

Have you started an SIP in mutual funds? Calculate your potential maturity amount now by using our free mutual fund calculator.

Tips for mitigating systematic risk

Despite being inherent to the market, investors can manage systematic risk through strategic planning and informed decision-making. While it cannot be completely eliminated, there are several methods investors can use to reduce its impact on their portfolios. Let’s understand them:

Vary your asset classes

Diversify your investments across different asset classes. This means do not put all your money into one type of investment, such as stocks, bonds, real estate, and other assets.

Such a variation spreads risk as different asset classes often respond differently to market changes. Thus, stability or gains in another might offset a downturn in one.

For example:

  • During a stock market decline, bonds might perform better.
  • By strategically investing in both stocks and bonds, you can balance your portfolio’s overall performance.

Develop a contingency plan

Having a well-thought-out contingency is essential. It helps you respond effectively to “market downturns”. Ideally, this plan should include strategies for:

  • Protecting your investments, such as setting stop-loss orders.
  • Maintaining an emergency cash reserve.
  • Having a predefined exit strategy for underperforming assets.

By being prepared for adverse market conditions, you can make more rational decisions and avoid panic selling.

Also read about: What Are High-Risk Mutual Funds

Stay informed about market conditions

Numerous studies have shown that investors who remain up-to-date with market conditions and economic indicators timely anticipate and respond to potential risks.

Hence, always stay aware of the recent trends and potential issues that could impact your investments. You can do so by regularly reviewing:

  • Financial news
  • Economic reports, and
  • Market analyses

Also, gain an understanding of the broader economic environment. Lay special focus on factors such as:

  • Interest rate changes
  • Inflation trends, and
  • Geopolitical events

This will help you make adjustments to your strategy as needed.

Relationship between beta and systematic risk

Beta (β) is a key measure in understanding and quantifying systematic risk. It measures the extent to which an individual stock or portfolio is affected by these broad market risks.

Investors must note that beta directly represents the systematic risk of a stock in the following manner:

  • A higher beta means higher exposure to systematic risk since the stock's returns are more sensitive to market movements.
  • On the other hand, a lower beta indicates lower exposure to systematic risk.

It has been commonly observed that several seasoned investors use beta to assess how much market risk they are taking on with a particular investment. This assessment helps in deciding an optimal asset allocation.

Difference between systematic risk and unsystematic risk

Systematic risk and unsystematic risk are two fundamental types of risk that investors need to understand when managing their portfolios. Systematic risk, also known as market risk, is the risk inherent to the entire market or market segment. It is caused by factors that affect the overall economy or the financial system.

Some popular causes of systematic risk are:

  • Economic recessions
  • Interest rate changes
  • Inflation
  • Political and regulatory changes
  • Natural disasters

Furthermore, systematic risk cannot be eliminated through diversification because it impacts several assets simultaneously.

On the other hand, unsystematic risk is the risk that affects a particular company or industry. It is caused by factors that affect only a specific business or industry. Some popular sources of unsystematic risk are:

  • Poor management decisions
  • New competitors
  • Technological advancements
  • Issues like labour strikes or production failures
  • Supply chain disruptions

Unsystematic risk can be managed through diversification. By holding a variety of investments, negative impacts on individual assets can be offset by positive performance in others.

Summary

Systematic risk affects the entire market due to external factors like economic conditions, political changes, and social developments. It cannot be eliminated through diversification. Some of the most prevalent types of systematic risks are market, interest rate, inflation, and exchange rate risks.

Most often, beta (β) is used to measure the systematic risk of a stock or portfolio, where a high beta indicates greater exposure to systematic risk. Although this risk is undiversifiable, investors can mitigate it to some extent by developing a contingency plan and staying informed about market conditions.

Are you planning to accumulate funds by investing in mutual funds? The Bajaj Finserv Mutual Fund Platform has listed 1,000+ mutual fund schemes online. Compare these mutual funds and use the lumpsum calculator and the SIP calculator to align these funds with your investment goals.

Essential tools for mutual fund investors

Mutual Fund Calculator Lumpsum Calculator SIP Calculator Step Up SIP Calculator
SBI SIP Calculator HDFC SIP Calculator Nippon India SIP Calculator ABSL SIP Calculator
Tata SIP Calculator BOI SIP Calculator Motilal Oswal Mutual Fund SIP Calculator Kotak Bank SIP Calculator

Frequently asked questions

What is called systematic risk?
Systematic risk is also known as market risk or undiversifiable risk. It is the risk inherent to the entire market and affects the overall economy or financial system.
What are the 5 systematic risks?
The five systematic risks are market risk, interest rate risk, inflation risk, currency risk, and political risk.
Which is the best example of systemic risk?
The 2008 global financial crisis is often cited as the best example of systemic risk.
What is the difference between systematic risk and specific risk?
Systematic risk affects the entire market, while specific risk is unique to individual assets or companies.
Is credit risk systematic or unsystematic?
Credit risk is considered unsystematic. That’s because it is specific to individual companies or issuers and does not affect the entire market.
How do you find systematic risk?
Systematic risk can be found by measuring the sensitivity of a security's returns to overall market returns. Usually, the beta coefficient (calculated using Capital Asset Pricing Model (CAPM)) is used for this purpose.
What is the systematic risk principle?
The systematic risk principle states that the expected return on an asset depends only on its systematic risk, which is measured by its beta coefficient.
Is systematic risk constant?
No, systematic risk is not constant; it fluctuates with changes in economic, political, and social conditions.
Show More Show Less

Bajaj Finserv App for All Your Financial Needs and Goals

Trusted by 50 million+ customers in India, Bajaj Finserv App is a one-stop solution for all your financial needs and goals.

You can use the Bajaj Finserv App to:

  • Apply for loans online, such as Instant Personal Loan, Home Loan, Business Loan, Gold Loan, and more.
  • Explore and apply for co-branded credit cards online.
  • Invest in fixed deposits and mutual funds on the app.
  • Choose from multiple insurance for your health, motor and even pocket insurance, from various insurance providers.
  • Pay and manage your bills and recharges using the BBPS platform. Use Bajaj Pay and Bajaj Wallet for quick and simple money transfers and transactions.
  • Apply for Insta EMI Card and get a pre-approved limit on the app. Explore over 1 million products on the app that can be purchased from a partner store on No Cost EMIs.
  • Shop from over 100+ brand partners that offer a diverse range of products and services.
  • Use specialised tools like EMI calculators, SIP Calculators
  • Check your credit score, download loan statements and even get quick customer support—all on the app.

Download the Bajaj Finserv App today and experience the convenience of managing your finances on one app.

Do more with the Bajaj Finserv App!

UPI, Wallet, Loans, Investments, Cards, Shopping and more

Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.