What is systematic risk?
Systematic risk, also known as market risk or volatility risk, is an inherent part of the overall risk that affects the entire market or a specific market segment. It arises from external macroeconomic factors and cannot be diversified away, making it non-diversifiable. Systematic risk is beyond the control of individuals, companies, or investors and encompasses unforeseen events that occur in everyday life. Unlike specific risks that pertain to individual companies or securities, systematic risk impacts the entire industry, making it a crucial consideration for all investments and securities.
Systematic Risk Explained
Systematic risk is characterized by its unpredictability and the impossibility of complete avoidance. Diversification alone cannot mitigate this type of risk; it can only be addressed through hedging or employing appropriate asset allocation strategies.
While diversification can help manage risks associated with specific industries, systematic risk encompasses broader factors such as interest rate fluctuations, inflation, economic recessions, and geopolitical conflicts. These factors have the potential to impact the entire market, making it difficult to mitigate their effects by adjusting positions within a portfolio of publicly traded equities.
To effectively manage systematic risk, investors should ensure that their portfolios include a diverse range of asset classes, including fixed income, cash, and real estate. Each asset class reacts differently to systemic changes, providing a level of protection. For example, during an interest rate increase, certain bonds may increase in value, while stocks of companies cutting back on spending may decrease. By incorporating income-generating securities into a portfolio, the potential loss in equity value can be offset to some extent during such events.
Types of Systematic Risk
Different types of systematic risk:
Interest-Rate Risk: This risk emerges from fluctuations in market interest rates and primarily affects fixed-income instruments, such as bonds. Changes in interest rates can lead to variations in the value of these instruments.
Market Risk: Market risk is associated with changes in the overall market prices of securities, particularly during a stock market correction. It refers to the potential for a significant decline in the value of investments due to broader market conditions.
Exchange Rate Risk: This risk arises from fluctuations in currency values, impacting businesses that engage in significant foreign exchange transactions. Changes in exchange rates can affect the profitability and competitiveness of companies operating in global markets.
Political Risk: Political risk is attributed to political instability within an economy. It encompasses uncertainties related to government policies, regulations, and geopolitical events that can impact business decisions and operations.