Definition
Systematic risk refers to the overall, unavoidable uncertainties and potential dangers that affect the entire market or large segments of it and cannot be eliminated through diversification. It’s often influenced by macroeconomic factors like inflation, changes in interest rates, or political instability. Systematic risk is also known as market risk or non-diversifiable risk.
Key Takeaways
- Systematic Risk refers to the risk inherent to the entire market or the whole market segment. It impacts a wide number of assets and is unpredictable, making it impossible to completely eliminate through diversification.
- This type of risk is usually caused by factors beyond the company’s control such as changes in inflation, tax legislation, political instability, war and changes in interest rates. These factors and shifts in the market can affect the overall financial performance of all the securities in the market.
- Systematic Risk forms a part of the deciding factor in the calculation of an investment’s return, known as beta. A positive beta means investment moves in the same direction as the market, while a negative beta signifies that the investment moves in the opposite direction of the market.
Importance
Systematic risk, also known as market risk or non-diversifiable risk, is a significant concept in finance because it represents the uncertainties and potential dangers that affect an entire market or the whole economy, not just specific businesses or industries.
Systematic risk factors include inflation rates, exchange rates, political instability, changes in interest rates, and natural disasters, which are outside of specific companies’ control.
It is important because it directly impacts the return on investment and cannot be eliminated through diversification.
Therefore, understanding systematic risk helps investors, firms, and financial institutions to optimize their risk management strategies, portfolio construction, and investment decisions.
Explanation
Systematic risk, sometimes referred to as non-diversifiable risk or market risk, is a significant concept in investment and finance management. Its primary purpose is to provide investors, mutual fund managers, and financial analysts with a measure of the potential, unpreventable risk associated with investing in the market as a whole.
Considered unavoidable, systematic risk is not tied to a particular equity, but rather the general market, economy, or investment environment, thus it cannot be eliminated through diversification strategies. Systematic risk is instrumental in forming a portfolio’s structure and making investment decisions.
For instance, investors may utilize systematic risk indicators, such as interest rates, inflation, and political instability, to predict future patterns in market movement and accordingly decide where to invest or divest. Financial institutions may assess systematic risk to determine baseline shifts in the stock market, pricing assets based on their exposure to this risk.
Moreover, measuring and understanding systematic risk is a key factor in determining an appropriate required rate of return on an investment considering overall market behavior. Hence, systematic risk plays a pivotal role in guiding investment decisions and strategy.
Examples of Systematic Risk
Market Downturns: A typical example of systematic risk is a market downturn or recession. This is a risk that affects all businesses and investments within a specific region or globally. As a result, stock prices can plummet due to factors like political instability, changes in interest rates, inflation, etc., which are beyond an investor’s control.
Interest Rate Changes: Changes in interest rates can significantly impact the entire economy. When the central bank raises interest rates, borrowing becomes more expensive, which can lead to reduced consumer spending and slowed business growth. This will not only affect specific sectors but the overall market, presenting a high level of systematic risk.
Global Pandemic: The COVID-19 crisis is a prime example of systematic risk. The pandemic affected the entire global economy, led to business shutdowns, employees losing jobs, stock markets plummeting, and general economic instability. It not only impacted specific sectors but every industry, demonstrating how devastating systematic risk can be.
Frequently Asked Questions about Systematic Risk
What is Systematic Risk?
Systematic risk, sometimes known as “market risk” or “un-diversifiable risk”, is the inherent risk associated with the whole market or the segment of the market. It cannot be eliminated through diversification.
How does Systematic Risk affect an investment portfolio?
Systematic Risk affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It can negatively impact the entire investment portfolio, regardless of the specific investments.
What is an example of Systematic Risk?
An example of systematic risk could include a major financial crisis or a significant change in interest rates. These events affect the entire market and cannot be predicted or mitigated through a diversified portfolio.
How can Systematic Risk be managed?
While Systematic Risk cannot be eliminated, it can be managed. Investors can reduce systematic risk by holding a diversified portfolio of investments and regularly rebalancing it. Utilizing various asset classes, different sectors, as well as global exposure can help in smoothing out potential returns over time.
What is the difference between Systematic Risk and Unsystematic Risk?
Systematic risk affects all sectors and cannot be eliminated through diversification. In contrast, unsystematic risk is specific to a single business or a specific industry and can be reduced through diversification.
Related Entrepreneurship Terms
- Market Risk
- Interest Rate Risk
- Volatility
- Inflation Risk
- Economic Risk
Sources for More Information
- Investopedia: It is a comprehensive online resource dedicated to assisting people understand complex concepts in finance and investing.
- Fidelity Investments: An international provider of financial services that offers information on a wide range of investment and financial topics.
- Bloomberg: One of the biggest financial companies in the world, with a vast amount of financial data and business analysis.
- The Balance: An online resource for personal finance advice, guidance, and financial literacy.
