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 a pervasive market risk that affects the entire financial system or a significant portion thereof. Unlike idiosyncratic risk, which is specific to a particular company or industry, systemic risk cannot be diversified away by investing in a variety of assets. Examples of systemic risk include economic downturns, geopolitical events, natural disasters, and significant changes in regulatory policies.
How can investors effectively mitigate the impact of systematic risk on their portfolios?
To effectively manage systematic risk, investors should employ a diversified investment strategy. This involves allocating assets across various asset classes, such as cash, real estate, and fixed-income securities. Each asset class exhibits distinct risk-return characteristics, allowing investors to potentially offset the negative impact of systemic events.
For instance, during periods of rising interest rates, certain fixed-income securities, such as newly issued bonds, may appreciate in value. Conversely, some equities may experience downward pressure as investors anticipate corporate cost-cutting measures. By maintaining an appropriate balance of income-generating assets, investors can potentially mitigate the adverse effects of interest rate fluctuations on their equity holdings.
The significance of systematic risk
Systematic risk, an inherent market risk, is a crucial factor that investors must understand. Given its unavoidable nature, exposure to systematic risk is virtually inevitable. Economic downturns, geopolitical events, and natural disasters can all impact the overall market.
Diversification, a common risk management strategy, is ineffective against systematic risk. Spreading investments across various assets and sectors does not shield investors from market-wide fluctuations.
To mitigate the impact of systematic risk, investors should consider a diversified portfolio encompassing different asset classes such as stocks, bonds, and real estate. This approach can help reduce overall portfolio volatility as different asset classes tend to react differently to systemic shocks.
While avoiding risky investments altogether can eliminate exposure to systematic risk, it can also significantly limit potential returns. A balanced investment strategy that incorporates risk management techniques is essential for achieving long-term financial goals.
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.
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.
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.
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.
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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.
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.
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.
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.
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