Systematic Risk
It is the risk that an entire market or market segment can be negatively impacted by uncontrollable factors, which can result in losses for investors.
What is systematic risk?
It is the risk that an entire market or market segment can be negatively impacted by uncontrollable factors, which can result in losses for investors. It is also known as “undiversifiable risk” or “market risk.”
The three main types are interest rate, inflation, and market risk.
The great recession and the recent war between Russia and Ukraine are examples of this risk. The two events were largely unpredictable and caused major losses to investors in numerous industries.
This is the overall risk brought on by variables beyond the company’s control, such as societal, political, and economic variables.
The sensitivity of a security’s return relative to the total market return can be used to measure it. The beta coefficient can be used to determine this sensitivity. It is calculated by projecting the return on investment against the return on a wide market index, such as the S&P 500.
Total risk is made up of systematic and unsystematic risk. Unsystematic risk differs from the others because it is more controllable and affects a small sector of the industry (ex: one company), as opposed to the whole market.
Likewise, the methods for protection against the two risks differ as well. Investors use asset allocation to protect themselves against market risk since diversification is less effective and mainly used to protect against unsystematic risk.
Unsystematic risk is known as “specific risk” or “residual risk.”
Types of Systematic Risk
It refers to the particular risk of an entire market or market segment that is unavoidable and is also frequently referred to as “volatility,” “market risk,” and “non-diversifiable risk.”
Systematic risk is both unforeseeable and unavoidable, so it is frequently considered challenging to avoid. Nevertheless, market-wide systemic risk is a given, reflecting the influence of monetary, geopolitical, and economic variables.
The major types of un-diversifiable risk are known to be as follows:
- Interest rate risk: It results from fluctuations in interest rates, which impact interest-bearing assets like bonds and debentures.
- Inflation risk: It is sometimes referred to as “purchase power risk” since it has a negative impact on a person’s ability to make purchases. Such a risk develops due to rising production costs, wages, etc.
- Market Risk: It influences the prices of a share, i.e., the prices will rise or fall consistently over a period along with other shares in the market. Diversification cannot reduce it; only hedging or the appropriate asset allocation strategy might. Other investment hazards, including industry risk, are driven by systematic risk. It is possible to diversify by investing in several stocks in different industries.
For instance, if an investor’s portfolio is mainly focused on healthcare industry stocks, he or she would diversify by investing in the tech and infrastructure industries.
However, among other significant changes, un-diversifiable risk includes fluctuations in interest rates, inflation, recessions, and wars.
These events are difficult to predict but could significantly impact the market, resulting in major losses for investors.
Changes in holdings within a portfolio of public stocks cannot minimize the impact of changes in these areas, which can impact the entire market.
Investors should ensure their portfolios contain various asset types, such as fixed income, cash, and real estate, as each will respond differently in the case of a significant systemic change to assist in managing systematic risk.
For instance, an increase in interest rates may enhance the value of some newly issued bonds while depressing the price of some company equities because investors will believe that executive teams are reducing spending.
Making sure that a portfolio has plenty of income-producing securities will help to reduce the value loss in some stocks in the event that interest rates rise. Additionally, the effects of non-diversifiable risk can be somewhat reduced by investors by diversifying their portfolios.
Residual risk, which affects a particular sector of the economy or type of security, is distinct from this kind of risk.
What is Unsystematic Risk?
This type of risk deals with a specific quality that affects a small part of the market, for example, a single company or industry.
It is also commonly referred to as “specific risk,” which refers to threats to a given business or sector. These dangers, however, do not simply affect one company at a time.
For instance, the stock price of a single company can be specifically at risk due to a bad manager.
However, if terrible management is commonplace in a certain industry, the stocks of numerous companies operating in that area may concurrently suffer from the dangers of poor management.
Unsystematic hazards can therefore be sufficiently broad to apply to various organizations simultaneously. What matters is that not all securities—or at least not a large majority of securities—inherently carry a residual risk.
Additionally, investors should be able to systematically seek a broad enough range of holdings in their portfolios to diversify away residual risks.
Comparing a risk’s instance to the market or industry can help you spot unsystematic dangers. The danger is probably not systemic if there is little to no significant link.
While some types of residual risk may be predictable to investors, it is relatively impossible to be aware of all possible risks.
For instance, a healthcare stock investor may be aware that a significant change in health policy is impending but may not be entirely aware of the specifics of the new regulations and how businesses and consumers will react.
Strikes, the results of legal proceedings, or natural disasters are some further unsystematic hazards. This risk is also characterized as a diversifiable risk because a portfolio’s adequate diversification can eliminate it.
Unsystematic risk cannot be expressed mathematically; rather, it must be estimated by deducting indivertible risk from overall risk.
On the WSO website, where we provide courses pertinent to financial modeling and risk assessment. The most relevant courses for this topic are the Excel Modeling Course, the Valuation Modeling Course, and the Real Estate Modeling Course.
Example: Systematic Risk and the Great Recession
The Great Recession illustrates un-diversifiable risk. Anyone who had investments in the market in 2008 witnessed the dramatic changes this economic crisis caused to the values of their holdings.
Riskier securities (such as those that were more leveraged) were sold off in significant quantities during the Great Recession, whilst simpler assets, such as U.S. Treasury bonds, increased in value.
The causes of the Great Recession stemmed from multiple factors. Firstly, the Fed maintained low interest rates until the middle of 2004.
These low interest rates, when coupled with legislative initiatives to promote homeownership, contributed to a sharp real estate and financial market bubble and a huge rise in the overall mortgage debt.
New subprime and adjustable mortgage loans permitted borrowers who might not have otherwise qualified to take out large house loans on the assumption that interest rates would stay low and property prices would keep rising indefinitely.
The real estate bubble was detrimental to the U.S. economy. It was almost impossible to anticipate due to mortgages being asset-backed securities, and their collateral could always be sold to minimize losses in case of default.
However, the additional financial innovations, together with unfair rating practices as a result of lenient government regulation, affected the certainty of mortgage-backed securities.
Another example, and a more recent one, is the war between Russia and Ukraine. The war and its attendant sanctions already significantly disrupted energy and food markets, with consequences likely to last well into 2023 and 2024.
The war has affected food production, western sanctions against Russian financial institutions, restrictions on the export of high-tech components, and the price of oil and gas.
These factors are causing inflation in North America to increase. They will likely lead to stagflation, rising interest rates, and a recession in Europe and the U.S. These consequences of the war are causing investors to lose a lot of money.
Systematic Risk vs. Unsystematic Risk
Total investment risk is the total systematic and unsystematic risk. Un-diversifiable risk is associated with the overall market, whereas residual risk is a risk unique to a company or industry.
Unsystematic risk is thought to be more controllable due to its concentrated nature and is more likely to be prevented as opposed to un-diversifiable risk.
Likewise, a common strategy for preventing loss from residual risk is diversification. At the same time, asset allocation is a typical strategy for protection against un-diversifiable risk.
Investment portfolio risk that is not reliant on specific assets is referred to as un-diversifiable risk and is caused by broad market conditions.
Interest rate fluctuations, recessions, and inflation are examples of certain systemic hazards. Beta, a measure of a stock or portfolio’s volatility concerning the broader market, is frequently used to calculate un-diversifiable risk.
On the other hand, company risk is a little more challenging to gauge or estimate.
The courses most applicable to this topic are the Excel Modeling Course, the Valuation Modeling Course, and the Real Estate Modeling Course.
Systematic Risk FAQs
Investors can manage un-diversifiable risk by ensuring 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.
Undiversifiable risk is unpredictable and impossible to avoid altogether, but investors can manage it by ensuring 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.
Therefore, ensuring that a portfolio has a sufficient number of income-producing securities will help to reduce the value loss in particular stocks.
The beta coefficient measures it. Greater un-diversifiable risk is associated with higher beta coefficients and vice versa. A beta coefficient of 1 indicates that the investment’s un-diversifiable risk equals the typical market-wide systemic risk.
The return on investment is projected against the return on a wide market index, such as the S&P 500, to determine the beta coefficient.
The weighted average of the beta coefficients of the various investments in a portfolio is used to calculate its systemic risk.
The capital asset pricing model estimates the needed return on an equity investment using the inherent un-diversifiable risk of the venture. The calculation below shows that the needed return will increase when the beta value increases and vice versa:
Required Return = rf + β × (rm - rf)
Where,
rf = risk-free rate
β = beta coefficient
rm = return on the broad market index
By examining the beta of a given security, fund, or portfolio, an investor can determine the un-diversifiable risk involved.
The investment’s beta compares its volatility to the market as a whole. The volatility of an asset relative to market volatility is measured by the beta of a stock or portfolio.
It can be used to gauge how dangerous a stock is in relation to market risk and is used as a stand-in for the stock’s systematic risk.
The investment has the same un-diversifiable risk as the market if its beta equals one. After the investor determines the un-diversifiable risk involved, he or she can act to reduce it using the diversification techniques of their choice.
You can learn about various financial topics on the WSO website, which offers courses relevant to financial modeling and risk assessment.
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