What is Systematic Risk?

When it comes to investing, most rational investors are discerning about the risks they take, aiming to be properly compensated for them. 

For the types of risks that don't offer commensurate rewards, like unsystematic risks, savvy investors use strategies like diversification to mitigate or even eliminate them altogether. 

But what if we told you that there's a category of risk that's unavoidable, a sort of "entry fee" to the investment carnival? 

Enter systematic risk: the inevitable, omnipresent risk that impacts the entire market and sticks with you no matter how diversified your portfolio is.

Here's all you need to know about how systematic risk works and your options for navigating it. 

Understanding Systematic Risk

Systematic risk is named the way it is for good reason. By breaking down its two components, investors can better grasp how it works:

• Systematic: In this context, the word systematic refers to something that affects an entire system rather than just a part of it. It implies that the factor in question is pervasive, influencing a broad range of elements within the defined system rather than originating from a specific instance. 

• Risk: Risk is the possibility of a loss occurring. In investment terms, risk refers to the possibility of losing money or volatility occurring. It represents the uncertainty inherent in any investment decision.

When combined, the term systematic risk describes a possibility of loss or volatility that impacts the entire investment market, stemming from a variety of broad, external and unavoidable factors.  

Unlike its cousin, unsystematic risk, which is specific to an individual company or industry, systematic risk is unavoidable and cannot be eliminated through diversification. 

In essence, systematic risk represents the inherent uncertainty tied to investing in any market and is the price you pay for the possibility of earning returns. 

Whether you're investing in stocks, bonds or any other financial instruments, the systematic risk will always be there, affecting the overall market. It’s like a background noise that’s always present, regardless of the individual components of your investment portfolio.

Causes of Systematic Risk

Now that it’s been established that systematic risk is unavoidable and affects the entire market and all types of investments, it becomes crucial to understand its root causes. Knowing what drives systematic risk can help investors better prepare for market fluctuations and potentially soften the impact on their portfolios.

Unlike the causes of unsystematic risk, which are idiosyncratic and specific to a company or industry, causes of systematic risk are external in nature. Here are some broad examples of various causes that give rise to systematic risk. 

Macroeconomic Factors Contributing to Systematic Risk

Macroeconomic factors refer to the large-scale events that affect an entire economy, as opposed to microeconomic factors that impact individual businesses or industries. They are a primary cause of systematic risk and can manifest in numerous ways. 

For example, when the economy enters a recession, consumer spending decreases and businesses cut back, affecting nearly all sectors and thereby the overall investment market. Even diversified portfolios are likely to suffer.

Inflation, another key macroeconomic factor, erodes the real value of money and impacts returns on investments. To combat this, central banks might also change interest rates to control inflation, affecting both the cost of borrowing and expected returns for assets. 

Global Events Affecting Systematic Risk

Global events are significant occurrences that impact multiple countries and their economies. These events often have a domino effect that ripples through global financial markets, affecting all types of investments. The effect is magnified by the interconnected, 24/7 nature of today's financial markets and the extensive commerce relations between different nations. 

The most obvious example is geopolitical tension and conflict, like the Russian invasion of Ukraine in 2022. Whether it's trade wars or armed conflict, the instability caused by these events often leads to uncertainty and market volatility, impacting asset values around the world. 

Natural disasters and pandemics are another category of global events that can severely disrupt economies. The COVID-19 pandemic, for instance, had a profound impact on global markets, affecting supply chains, consumer behavior and asset prices.

Impacts of Systematic Risk on Financial Markets

Systematic risk, also known as market risk, affects all investments. It comes from economic events that impact the overall market. Examples include recessions, interest rate changes, and geopolitical tensions. Unlike unsystematic risk, which is linked to specific companies or industries, systematic risk cannot be reduced by diversifying investments. This risk influences asset prices and investor behavior, making it important for all market participants. Understanding systematic risk is key for managing portfolios and making informed decisions. It affects market volatility, returns, and economic growth. The sections ahead will explore the different aspects and effects of systematic risk in financial markets.

Market Volatility

Systematic risk is the inherent risk affecting the entire financial market or a large part of it. It can be triggered by factors like macroeconomic trends, interest rate changes, natural disasters, and geopolitical events. Such events often cause heightened market volatility as investors respond to new information. This volatility leads to rapid price changes in equities, bonds, and other assets. As a result, traders and investors may find it challenging to make informed decisions. Increased volatility can create a cycle where uncertainty drives more price swings, impacting overall market stability and investor confidence.

Investment Behavior

Systematic risk affects how investors behave. When uncertainty or market downturns occur, investors become more risk-averse. They often move their money into safe-haven assets like U.S. Treasury bonds, gold, or blue-chip stocks. This change in investment strategy can lead to large capital outflows from riskier assets, such as high-yield bonds or emerging market equities. As a result, prices for these assets may decline, worsening market downturns. Additionally, institutional investors, like pension funds and mutual funds, may adjust their portfolios to lower their exposure to systematic risk. This adjustment can further amplify the market's impacts as they sell off positions based on new risk assessments.

Asset Correlation

Systematic risk has important implications for asset classes. It increases correlations among them during market stress. Normally, diversification relies on the idea that different asset classes respond differently to economic events. This reduces overall portfolio risk. However, when systematic risk rises, asset correlations tend to increase. Investments that usually behave independently may start to move together. For instance, during a financial crisis, equities and high-yield bonds may decline at the same time. This reduces the benefits of diversification. As a result, investors may face larger-than-expected losses. Portfolios may not provide the intended risk mitigation during turbulent times.

Mitigating Systematic Risk

Systematic risk is an unavoidable aspect of investing in financial markets. Because it's inescapable, the focus shifts from attempting to eliminate it to managing it effectively. 

In fact, the only way to completely avoid systematic risk would be to abstain from investing altogether, which would also mean missing out on potential returns.

With that in mind, here are some possible ways investors can manage systematic risk in their portfolios.

Diversification as a Key Risk Management Strategy

Diversification stands as a cornerstone in the realm of risk management, even though it can only mitigate, rather than eliminate, the effects of systematic risk. This contrasts with unsystematic risk, where diversification can virtually eradicate the risk associated with individual assets or sectors.

One effective diversification strategy involves spreading investments across different asset classes such as stocks, bonds, real estate and commodities. Asset classes often react differently to the same systematic risk factors, providing a cushion against widespread market downturns. 

Another approach is geographic diversification, which aims to minimize the impact of country-specific risks, such as political instability or economic downturns in a particular nation.

To illustrate the value of diversification across both dimensions, consider the period from 1999 to 2009, often termed the lost decade for U.S. stocks. During this time, the U.S. market experienced a prolonged period of stagnation following the dot-com bubble. 

However, investors who diversified into emerging market stocks and bonds during this period generally saw positive returns. 

Source: Portfolio Visualizer

By diversifying both in terms of asset classes and geography, these investors were able to mitigate some of the systematic risk associated with U.S. market and economic stagnation. 

This example illustrates that while diversification cannot eliminate systematic risk entirely, it remains a key strategy for reducing its impact and for capturing opportunities even in challenging market conditions.

Hedging Techniques to Manage Systematic Risk

While diversification is a more passive form of risk management, occurring largely in the background and without direct investor intervention, hedging offers a more active approach to managing systematic risk. Hedging involves taking an investment position intended to offset potential losses or gains in another asset, effectively reducing your exposure to unwanted risks.

Financial derivatives like futures and options are common tools for hedging. For example, buying put options on a stock index like the S&P 500 can protect against downward market moves. If the market declines, the value of the put option is likely to increase, offsetting losses.

Short-selling, another active technique, involves selling borrowed assets with the intention of buying them back at a lower price, thus profiting from a decline in asset value. For example, an investor can sell short shares of an S&P 500 ETF in anticipation of a market decline. 

Another advanced method for hedging systematic risk is using volatility futures, which aim to profit from increases in market volatility. These instruments can act as an insurance policy against periods of rising market turmoil, which are usually caused by systematic risk. 

However, it's important to remember that these hedging techniques don’t directly address the sources of systematic risk; they're merely mitigating the downstream consequences. For instance, a put option on the S&P 500 won't stop World War III, but it could help protect your portfolio from the ensuing market turmoil.

Lastly, it's worth noting that hedging techniques often come with their own set of challenges. They can be complex and costly and sometimes may behave unpredictably, potentially acting contrary to investor expectations. Because of these factors, hedging is generally considered more appropriate for experienced investors who understand the risks and costs involved.

Examples of Systematic Risk in Real-Life Scenarios

One of the most salient examples of systematic risk impacting global financial markets in recent history is the COVID-19 crash of March 2020. This event underscores the pervasive nature of systematic risk, as it affects virtually all types of investments around the world.

During this time, the world literally shut down, leading to supply chain disruptions, business closures and mass unemployment. As the pandemic unfolded and countries implemented lockdown measures, uncertainty gripped global markets.

It wasn't just the U.S. stock market that experienced a drastic fall; international developed markets and emerging markets also tanked. 

Source: Portfolio Visualizer

However, other assets like U.S. bonds and gold held up better, despite still suffering losses during the brunt of the initial outbreak.

Source: Portfolio Visualizer

This episode serves as a stark reminder that systematic risk is ever-present and can manifest suddenly, affecting a wide array of investments simultaneously. It also underscores the importance of risk management strategies like diversification and hedging to mitigate, though not eliminate, potential losses during such unforeseen events.

Navigating Systematic Risk

Navigating the choppy waters of investment isn't easy, and systematic risk serves as a reminder that some degree of risk is unavoidable in the financial markets. 

However, the presence of systematic risk shouldn't instill panic or deter anyone from investing; rather, it should be viewed as the price of admission for the opportunity to earn returns. It is part and parcel of investing. 

However, while investors can’t escape systematic risk entirely, they're far from powerless. Effective risk management strategies like diversification can mitigate its impacts, allowing for a more resilient investment portfolio. 

Additionally, for those who are more experienced and willing to navigate complex financial instruments, hedging techniques offer an active approach to managing systematic risk to a greater degree. 

In essence, systematic risk may be inevitable, but it doesn't mean you have to resign yourself to its worst effects. Through thoughtful risk management, you can not only endure these market upheavals but also thrive, achieving better risk-adjusted returns in the long term.

Frequently Asked Questions