What is Systematic Risk?

Investing is all about striking the right balance between risk and return. There are different types of risks in the stock market and there are ways to mitigate them. All investors naturally want to be compensated well for the risks they undertake. But, there’s one category of unavoidable risk, something like an “entry fee” for your investment journey. It is known as systematic risk.

In this guide, we explain systematic risk and how to manage it. 

Understanding Systematic Risk

There are two types of risk in the market- systematic and unsystematic. An unsystematic risk is also called diversifiable risk. It impacts individual investments and can be mitigated. On the other hand, a systematic risk impacts the entire market and is omnipresent. No matter how the portfolio is diversified, systematic risk will remain. 

Systematic risk can be broken down into two components: systematic and risk. The word systematic refers to something that affects the entire system and not just a part of it. It affects the entire system and all of its elements. Risk means the possibility of a loss. In the investing world, risk means the chances of losing your money. 

Thus, systematic risk describes the possibility of a loss or volatility that can impact the entire market and the risk arises from uncontrollable, unavoidable, external factors. It cannot be eliminated through diversification but is inherent and tied to investing. It is the price you pay for the possibility of generating returns on your investment. Irrespective of the type of investment product you choose, systematic risk will always be present. It works like background music, always there, no matter the situation or the characters.

Causes of Systematic Risk

Now that you know systematic risk is unavoidable, it is important to understand what causes it. This will help you prepare for market volatility and ensure it has little impact on your portfolio. Here are some factors that cause systematic risks to arise. 

Macroeconomic Factors

Large-scale events that affect the entire economy are known as macroeconomic factors. Inflation or recession can cause a massive change in the economy. They are a primary cause of systematic risk. For example, when the economy enters a period of recession, consumer spending will drop and it will affect several businesses and the investment market. Even if you have a diversified portfolio, it will suffer. In an inflationary period, central banks change interest rates, which impact borrowers, their cost of living and the expected return on assets. 

Global Events 

Large-scale events affect the economy and global events affect the global world. It impacts multiple countries and economies. One event can have a domino effect that ripples through different markets and affects investments. An example is the Russia-Ukraine conflict that started in 2022. The conflict caused instability in multiple markets and led to high market volatility. It doesn’t always have to be an armed conflict; even a trade war can have a similar impact. 

The COVID-19 pandemic left a profound impact on global markets and brought about a change in supply chains, consumer behaviour and returns generated on assets. A natural disaster or pandemic cannot be controlled or predicted by anyone and such risks will always have an impact on your portfolio. The event explains the nature of systematic risks and how they impact every investment globally. 

International and emerging markets tanked and it wasn’t limited to the stock market. Even the bond yields dropped, affecting all types of portfolios. The pandemic is a reminder that systematic risk is always present and can impact anyone at any time. This highlights the importance of implementing risk management strategies to reduce the potential losses in case of an unforeseen event. 

Impact of Systematic Risk on Your Portfolio

Since systematic risk cannot be reduced by diversification, it is essential to understand how it impacts your portfolio. The risk will have an impact on consumer behaviour, asset prices and anticipated returns. 

Market Volatility

Systematic risk will impact the entire financial market. The risk can be triggered by a global event, macroeconomic trend or natural disasters. Such events can cause market volatility and lead to rapid changes in asset prices. It could impact equities, bonds and all other investment assets. This makes it difficult for investors to make the right decisions and a higher market volatility can lead to a cycle where there are price swings and uncertainty, ultimately impacting investor confidence.

Investment Behavior 

Systematic risk will impact how investors behave. If there is a market downturn, investors will become risk-averse and move their money into safe assets like bonds or gold. This will lead to capital outflow from riskier assets like equities and the prices for them will decline. A further dip can worsen the market downturn since institutional investors like mutual funds and pension funds also adjust their portfolios to lower the systematic risk. This adjustment by individual and institutional investors will amplify the market’s impact and cause volatility. 

Asset Correlation

Systematic risk can increase the correlation among different asset classes during periods of volatility. While diversification reduces asset-specific risks, systematic risk leads to an increase in asset correlations. The assets that normally behave independently tend to start moving together. In a financial crisis, investors might see equities and bonds dip at the same time. It reduces the benefits of diversification and leads to higher-than-expected losses. In turbulent times, a diversified portfolio may not provide the intended risk mitigation. 

Ways To Mitigate Systematic Risk 

Since systematic risk is unavoidable and inescapable, investors need to move away from looking for ways to eliminate the risk. Instead, you should look for ways to handle it effectively so that the losses are reduced to a minimum. 

Diversification Remains a Key Strategy

When it comes to risk management, there is nothing as solid as diversification. It will only mitigate systematic risk and not eliminate it. You can build a diversified portfolio by spreading your investments across different asset classes like stocks, real estate, bonds, ETFs or commodities. 

Each asset class will react differently to the same systematic risk. Hence, you will have a cushion in case of a market downturn. Alternatively, you can consider geographic diversification, which reduces the country-specific risks. The economic downturn in one country will not have an impact on another. Today, it is possible to invest in assets across the world and if you can build a portfolio of global stocks and bonds, you will be able to minimize the impact of systematic risks. 

Hedging 

Hedging is an active approach towards handling systematic risks. It involves taking an investment position that will help offset the potential gains or losses in another asset and reduce your exposure to the risks. Futures and options are common tools used for hedging. For example, you can buy a put option on a stock index like the S&P 500, which will protect against the downward market moves. In case the market dips, the value of your put option is likely to increase, ultimately offsetting the losses. 

Another technique is short selling. It involves selling a borrowed asset with the intention of repurchasing it at a lower price and profiting from the decline in asset value.

Volatility futures is another method for hedging systematic risk. It aims to profit from rising market volatility. 

The above-mentioned methods work like an insurance policy during market turmoil. However, they often come with their own set of risks. These techniques will not directly impact the source of systematic risk but will reduce the consequences. 

There is no guarantee that these techniques will eliminate losses since the market could move against investor expectations. Hedging is ideal only for experienced investors who know the risks and costs involved in the process. Beginner investors should consider portfolio diversification to reduce the impact of systematic risks. 

Navigating Systematic Risk

The only way to eliminate systematic risk is to never invest and this means losing an opportunity to make money. Navigating the investment industry is not easy and there will always be a certain element of risk in the market. But the presence of systematic risk should not deter you from investing. It should always be looked at as part and parcel of investing. 

Efficient risk management strategies like diversification can build a resilient investment portfolio. And if you’re experienced and willing to take the risk, you can consider hedging techniques to manage the risk to a greater degree. Through thoughtful risk management, you can handle the market ups and downs and thrive in your investing journey. 

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