What is the systematic risk of investments?
Companies and investors face different kinds of risks that affect their profit or returns on their investment. The systematic risk is the risk caused due to macroeconomic factors affecting the economy that cannot be controlled by either the companies or investors. As a result of this risk, the returns which are earned from investments that are risky will fluctuate. Some factors which affect the profit of a business can be controlled by the business and its management to some extent and are the unsystematic risk of doing business. These factors include labor disputes and mismanagement for a company. The total risk involved for investors can be categorized into unsystematic risk and systematic risk. Let us define systematic and unsystematic risk in finance.
Systematic risk factors are usually macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, or some factors as wars, corona pandemic, etc. The best example of a systematic risk example that individual companies cannot control is the 2019–20 coronavirus pandemic.
Systematic Risk explained
Many unexpected events occur regularly which cannot be controlled by the investors and these are the systematic risk of doing business, investing. This risk can be only avoided by avoiding any investment which is risky. In reality, this is not a viable option for most investors since the only investment options available to them, in this case, would be the CDs and T-bills of government-related organizations. Hence every investor should be prepared to consider these systematic risks while deciding their strategy for investment if they want good returns.
To compensate for the systematic risks while investing, most investors will expect a premium on their risky investments. To explain with an example, if a 5% return is offered for a T-bill which is risk-free, the investor will expect 10% returns while investing in shares. The investor hopes that the additional 5% return on shares will compensate for the systematic risk he is taking while investing in shares. Due to macroeconomic factors, the investor can also make a loss on his share investment and this is why he tries to get better returns.
Systematic risk should be considered the opportunity cost of choosing a particular investment when less risky options are available. Investors consider their personal choices and also financial goals while choosing their investment options. For a T-bill with a 3% return, though the returns are low, there are no systematic or other risks for the investor. On the other hand, for a stock offering 15% returns, it is possible that the investor will lose his money, and there is also the opportunity cost which should be considered when he chooses this option compared to the low-risk option of T-bill.
It is usually not possible for investors to avoid all systematic risks if they wish to get good returns. However, they can reduce the systematic risk involved by diversifying the investment. This ensures that even if they make a loss from one investment, the profits from other investments will compensate for the loss. Additionally ensuring that resources are utilized properly and procedures are followed to ensure that only quality investments are chosen, can greatly reduce the risk involved. When a company is being sold, it is important to consider the systematic risk involved since the buyer will be willing to pay a lower amount for the business to compensate for the risk involved in the deal.
Managing Systematic Risk and Unsystematic Risk
Investing money is risky, the investor may lose some of their money. Experts believe that the greatest risk for investors is losing their capital amount permanently. Hence to avoid losing their capital completely, investors have to adopt a strategy for managing the risk for their investment portfolio. For this, they will have to understand how unsystematic and systematic risk will affect their portfolio. They will also have to find out the most effective way of reducing the risks involved in their investment. We can mitigate risks using Standard Operating Procedures (read article sop meaning)
Systematic risk is related to a large number of factors affecting the entire investment market, it is not related to a specific risk related to a particular investment. Changes in the bank and other interest rates, inflation, fluctuation in currency exchange rates, wars, recession are some of the macroeconomic factors that affect the systematic risk. These macroeconomic factors affect both the direction in which the market moves and the volatility. The systematic risk cannot be controlled by a single company or individual.
Asset allocation is widely used to reduce the systematic risk involved to some extent. Since the value of asset categories will change in a different manner to changes in macroeconomic data, investors can reduce the volatility in their portfolio by investing in asset classes with a low correlation to each other. When the value of some asset categories like domestic equities, stocks, are increasing, others like bonds, cash will decrease in value, and vice versa to reduce volatility. Experts also believe that they should consider the value of the assets while investing. They should invest more in bargains, and avoid investing in assets that are considered overpriced. To reduce systematic risk, they should also invest in cash which is often not appreciated.
Risk which is specific to a company or industry is considered an unsystematic risk. This risk can be attributed to a specific investment or investment group. It is not linked to the returns from the stock market. It also called the diversifiable, residual, or specific risk. These risks can be controlled to some extent by the industry sector or company. These risks are divided into financing, business, credit, product, legal, liquidity, political and other risks. Unsystematic risk can be almost completed eliminated by diversification. The investor with only one stock or bond will suffer great losses if there is a problem with the stock. On the other hand, if the investor has a diversified portfolio of 40 different investments, the losses to problems in a particular stock will affect the portfolio less.
Probability, Expected Portfolio Value
For calculating the expected value of a portfolio, the possible returns and probability of each return will be considered. One way to measure risk is determining the deviation and how the probability of the deviation compares with the expected returns. Diversification reduces the unsystematic risk and portfolio risk is mitigated by allocating assets properly. Mitigating risk ensures that the portfolio manager has more profitable assets with higher risks resulting in portfolio optimization. The portfolio manager can handle a specific amount of risk and if the systematic and unsystematic risk is lowered, he can opt for investments offering higher returns.
Systemic vs. Systematic Risk: What’s the Difference?
In order to understand systemic vs. systematic risk both of these terms a bit more closely. If an event causes a major setback to an economy or a particular industry then it is known as a Systemic Risk but if the market experiences a consistent and everlasting risk for an extended time due to a number of reasons then it is known as Systematic Risk. The information provided in this write-up will help you in understanding the basic differences in these two terms.
Difference between systemic risk and systematic risk
Systemic risk can give a complete shock to the system from outside whereas the shock provided by the systematic risk based on a number of factors can be ongoing and on a day-to-day basis. For instance, the financial crisis of 2008 that has triggered a massive implosion in the world market was based on the threat of failure of one of the major banks of the US. It is a good example of systemic risk. The risks based on the changes in interest rates, corporate health, geopolitical issues, etc. are some of the examples of systematic risk.
Moreover, it is hard to predict and scale the systemic risks whereas in some cases it is easier to predict and scale systematic risks
Systemic risk can be defined as the risk related to the complete breakdown of a sector, industry, financial institution, business, financial system, or the entire economy. Some of the small but particular problems like leakage of information of website users or flaws in the security of bank accounts etc. can also come in the category of systemic risks. In other words, systemic risk can be defined as a substantial danger occurred in a company that can widely influence the entire financial system.
Systematic Risk, on the other hand, is not easy to define as it is a bit vague. In simple words, it can also be used as the term market risk’ which involves the dangers faced by the entire market and is not easy to resolve even if you spread your holding into several branches. The basis of such widespread risks for the market can be the period of weakness or recession in the economy, decline or rise in interest rates, wars, fluctuations in the prices of the commodities or currencies, etc. However, the systematic risk can be managed but cannot be eliminated by following the strategy of allocating the assets in different ways.
Some examples of systemic vs systematic risks
In 2008, the failure of Lehman Brothers that has affected the entire economy and financial system is one of the most recent examples of systemic risk. This failure has caused a domino effect on the financial system of the entire world because Lehman Brothers was a big company. The government has to intervene to resolve this problem.
One of the latest examples of systematic risk is the economic recession faced by the entire world in the late 2000s. at that time, people who have invested in the market, have seen drastic changes in the value of their investments due to this economic crisis. The assets of different classes were affected differently due to this recession.
Thus, systemic risks are basically different from systematic risks.