Anyone who was invested in the market in 2008 saw the values of their investments change drastically due to this economic event. Riskier securities that were more leveraged were sold off in large quantities. An investor can identify the systematic risk of a particular security, fund, or portfolio by looking at its beta. It measures how volatile that investment is compared to the overall market. A beta of greater than one means the investment has more systematic risk than the market. A beta equal to one means the investment carries the same systematic risk as the market.

Systematic risk can’t be mitigated through diversification, only through hedging or by using the correct asset allocation strategy. Systematic risk is unpredictable and impossible to completely avoid. It’s also known as undiversifiable risk, volatility risk, or market risk. It’s the result of macroeconomic events that affect the market as a whole and cannot be controlled, at least by an investor. It would consider the entire economy, and the analyst would get a better types of systematic risk picture as this provides a holistic view of the whole economy.

Though systematic risk cannot be reduced by diversification, it does come a long way in understanding and identifying risks. Systematic risk refers to the risks inherent in an entire market or economy rather than a specific company or industry. Although systematic risk impacts the entire economy, the scale and magnitude of the same may differ across sectors, and thus it becomes crucial to study them in isolation.

#3 – Helps in Risk Identification

An increase in interest rates will make some new-issue bonds more valuable while causing some company stocks to decrease in price as investors perceive executive teams to be cutting back on spending. It would be difficult to assess the impact on various sectors, stocks, and businesses in an isolated manner. There may be sector-specific risks and factors that impact these businesses. Studying them in isolation rather than considering the holistic view is essential to understand the same better. Systematic risk is both unpredictable and impossible to completely avoid but investors can manage it by ensuring that their portfolios include a variety of asset classes. These might include fixed income, cash, and real estate, each of which will react differently to an event that affects the overall market.

How Can an Investor Manage Systematic Risk?

Systematic risk can arise from factors such as inflation, recessions, changes in interest rates, and other macroeconomic events that impact the overall market. Thus, through beta we can calculate the return on the asset with respect to market returns. The returns will be calculated for both the asset as well as the market index.

However, to gauge and understand the risk inherent in any specific business or sector, one needs to study them in isolation, and systematic risk may not be able to help much in this regard. An increase in interest rates will make some new-issue bonds more valuable while causing some company stocks to decrease in value. Making sure that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities. Then, to calculate systematic risk, we calculate the covariance between the market index return and asset return. The term covariance identifies how the asset prices fluctuates in relation to changes in the market. We also calculate the variance that is the movement of the asset in relation to the mean.

• They may need to analyze sector-specific behavior and factors that affect the same.
• It would consider the entire economy, and the analyst would get a better picture as this provides a holistic view of the whole economy.
• For example, when the housing mortgage burst in 2007, the systematic risk became a nationwide phenomenon.

#1 – Mass Impact

It would serve as a proxy for the risk of the entire economy rather than having to find out the risk inherent in each sector in isolation. Examples of finance systematic risk that would affect the whole economy as described under the various types are illustrated in the example below. Such risk is dangerous to the economy as the same, when rampant, may indicate a slowing economy, sluggish business warning of an impending recession. It has a wide-scale impact and repercussions, often spreading from one sector to another or even from one economy to another, for that matter, when they are interlinked. Ensuring that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities in the event of an interest rate rise.

How To Reduce?

Since systematic risk affects the entire economy, it helps one understand the interlinkage and repercussions. For example, when the housing mortgage burst in 2007, the systematic risk became a nationwide phenomenon. This liquidity crunch affected the financial markets, which affected other economies and led to a steep fall in trade and investment globally. You can look at its beta if you want to know how much systematic risk a particular security, fund, or portfolio has.

#4 – Helps in Understanding Repercussions

• Risk diversification goes on to form the basis of insurance and also that of investment.
• You can look at its beta if you want to know how much systematic risk a particular security, fund, or portfolio has.
• However, the presence of systematic risk of portfolio affects everything at the same time.
• Shifts in these domains can affect the entire market and can’t be mitigated by changing positions within a portfolio of public equities.

Some common disadvantages of the concept of systematic risk of portfolio are given below. We need to collect the financial information of the past year years related to the asset for the purpose of analysis. Systematic risk is different from systemic risk which is the risk that a specific event can cause a major shock to the system.

Since it is inherent in the broader market, it can affect any type of investment portfolio and is a crucial factor while taking important investment decisions. Shifts in these domains can affect the entire market and can’t be mitigated by changing positions within a portfolio of public equities. Systematic risk can be mitigated through diversification but the risk would still affect all investments in a particular market or economy. Investors must be aware of the potential for systematic risk when making investment decisions as a result. They can take steps to manage this risk through strategies such as asset allocation and risk management.

What’s the Relationship Between Beta and Systematic Risk?

The systematic risk may not give the analyst a complete picture in such a scenario. They may need to analyze sector-specific behavior and factors that affect the same. By understanding the systematic risk that would affect the economy, the investor would tend to get an idea of how much his portfolio is exposed to non-diversifiable risk. The systematic risk is a fundamental concept in the field of finance which investors or finance analysts need to understand and identify.

Understanding Systematic Risk

Though the non-diversifiable risk is a systematic risk that impacts the whole economy, the scale of impact may differ across the business and sectors. Here it becomes essential to understand and study these sectors with a view different from that of the entire economy. Risk diversification goes on to form the basis of insurance and also that of investment. However, the presence of systematic risk of portfolio affects everything at the same time. By undertaking a probabilistic approach of its impact on the risk profiling of the portfolio of the insurance companies, this approach helps to understand and identify risks better.