Systematic risk

3 key takeaways

• Systematic risk, also known as market risk, impacts the overall market and cannot be mitigated by diversifying a portfolio.
• It arises from macroeconomic factors like inflation, interest rates, political instability, and global events.
• Understanding systematic risk is crucial for investors to assess the potential volatility and overall risk of their investments.

What is systematic risk?

Systematic risk, also known as market risk or non-diversifiable risk, is the risk associated with macroeconomic factors that impact the entire market or a significant portion of it. Unlike unsystematic risk, which affects specific companies or industries and can be mitigated through diversification, systematic risk affects all investments to some extent and cannot be avoided through diversification alone.

Systematic risk is driven by broad economic, political, and environmental factors, such as changes in interest rates, inflation, recessions, geopolitical events, and natural disasters. These factors influence the overall market and can lead to widespread volatility and fluctuations in asset prices.

How does systematic risk work?

• Macroeconomic factors: Systematic risk arises from broad economic conditions that affect the entire market. For example, changes in monetary policy, economic growth rates, and fiscal policy can impact the performance of all investments.
• Interest rates: Fluctuations in interest rates can affect borrowing costs, consumer spending, and business investments, influencing the overall market. Higher interest rates generally lead to lower stock prices as borrowing becomes more expensive.
• Inflation: Rising inflation erodes purchasing power and can lead to higher costs for businesses, impacting profit margins and stock prices. Inflation can also affect bond prices as interest rates rise in response.
• Political events: Political instability, changes in government, and regulatory shifts can create uncertainty and volatility in financial markets. For example, trade wars, elections, and changes in government policy can impact market performance.
• Global events: Events such as natural disasters, pandemics, and geopolitical conflicts can disrupt markets globally, leading to widespread volatility and risk.

Examples of systematic risk

• Global financial crisis (2007-2008): The financial crisis affected the entire global market, leading to significant declines in stock prices, increased volatility, and widespread economic disruption. This was a clear example of systematic risk impacting all sectors.
• COVID-19 pandemic (2020): The pandemic caused global economic downturns, market volatility, and disruptions across various industries, demonstrating how a global health crisis can lead to systematic risk.
• Brexit: The United Kingdom’s decision to leave the European Union created political and economic uncertainty, impacting financial markets not only in the UK but also across Europe and the rest of the world.

Understanding systematic risk is crucial for investors to assess the potential volatility and overall risk of their investment portfolios. While it cannot be eliminated, investors can manage systematic risk through asset allocation, hedging strategies, and staying informed about macroeconomic trends and global events. For further exploration, consider studying how different asset classes respond to systematic risk, the role of diversification in managing other types of risk, and strategies for mitigating the impact of systematic risk on investment portfolios.

It is also partly idiosyncratic: every should be distinguished from the systemic risk.