Digging into systematic risk: types and an example

Investing in the stock market requires knowledge and understanding because of the risk it contains. Systematic risk is one of the main ones in the market. Let us see below what it is, what types it is divided into, and if you can mitigate it.

Definition of systematic risk

Systematic is the type of risk that affects the whole market or its significant section. No one can diversify this risk by holding a diversified portfolio of specific assets since it affects the entire market, hence also referred to as undiversifiable or volatility risk. 

Systematic risk does not impact a single asset but a group of related instruments. This type of risk is often caused by things or events that a single individual cannot control, such as political ones like instability or elections, monetary policies, recession, natural disasters, and inflation.

Difference between systematic and unsystematic risk

Unsystematic risk is the opposite of systematic one. It is the type of risk whose specific factors only affect a particular industry or individual assets. It is also referred to as market or diversifiable risk since you can control it by holding a well-diversified portfolio of investments.

For instance, if a particular business experiences a decline in the value of its brand or its sales decrease, it may result in the lesser value of its securities. If you had invested in this company’s stocks, you would experience unsystematic risk. However, if you hold a diversified portfolio of stocks across many different industries, the effect of the decline in that one firm would be reduced.

Types of systematic risk

Systematic risk comes in different types, and the main ones are:

1. Interest rate risk

It is caused by changes in interest rates, and on most occasions, it affects the value of fixed-income assets such as bonds, debentures, and the cost of borrowing. The price of such assets is inversely proportional to the rate of interest in the market, hence affected much by this risk.

2. Political risk

This type of risk happens due to political uncertainties caused by elections, changes in government policies, and geopolitical events, among others.

3. Market risk

Changes in the price of assets are the leading cause of systematic risk; hence the term systematic risk is also referred to as market risk. It occurs when investors tend to follow a certain direction of the market. Therefore, if the market declines, the result will also be a decline in the performance of the share prices of companies whose performance has been good.

4. Inflation risk

This type is also known as purchasing power risk. Inflation refers to a consistent and sustained increase in the price level of goods in an economy, which results in the erosion of the purchasing power of funds. Therefore, for the number of funds that people pay, it was previously possible to buy more goods or services. In the same way, if the investors’ income does not increase during inflation, it would mean their lower income in real terms.

5. Foreign exchange risk

This type of risk is related to fluctuations and uncertainties in exchange rates between different currencies. It can impact the value of international investments and companies that transact foreign exchange securities, including gold, and those that deal with exports and imports of products or raw materials.

Example of systematic risk

An excellent example of systematic risk is the Great Recession, which lasted from 2008 to 2009. Most investors were affected, especially those that put funds in leveraged securities, more so the subprime mortgage, which belongs to a group of riskier securities. These securities were sold off in large quantities because their value had decreased and interest rates increased, whereas other non-risker securities, such as U.S. Treasury bonds, increased in value.

How to know the systematic risk of an asset?

To determine the systematic risk or volatility of the asset or portfolio you wish to invest in (relative to the market), you need to calculate its beta coefficient. It is equal to covariance (stock returns, market returns) divided by variance (market returns). Here is the formula to apply:

Coeff (β)=Cov (Re​, Rm​) / Var (Rm)

Once you calculate and get the value for beta, here is how you can interpret it:

β < 1 means the investment has lower systematic risk/volatility than the market.

β = 1 means your investment’s systematic risk equals market risk.

β > 1 means the portfolio you wish to invest in has higher volatility compared to the market.

How to manage systematic risk?

You may not completely eliminate systematic risk because of its nature of being inherent in the market. However, you can always manage it using different approaches, such as:

1. Diversification

You can diversify your portfolio by investing in different assets, as this will help reduce the impact of the risk. Just spread your investments across several asset classes, geographic regions, and industries.

2. Hedging

A hedging strategy will help you take an offsetting position in different assets, which will, in turn, reduce the impact of market movements. For instance, you can use options or futures contracts to hedge against market risk.

3. Asset allocation

You can also manage systematic risk by allocating a part of your portfolio to an asset class with less volatility, such as real estate or bonds which will help reduce the impact of market fluctuations.

The bottom line

Analyzing systematic risk is very vital for every investor. You will not only get the overall picture of the whole economy but also know what to do to mitigate the risks associated with investing in a particular portfolio.

Note that systematic risk may not have the same magnitude in all sectors of the economy. Therefore, you should evaluate the risk inherent in each individual firm or industry you wish to invest in by examining it in isolation.