Understand Systematic risk, its meaning, types, formula, and example

Investing in the stock market carries risks. While some risks are specific to individual stocks, sectors or companies, others affect the broader market and cannot be avoided through diversification. This market-wide risk that influences a large number of assets is known as systematic risk.

As an investor, it is critical to understand systematic risk, its causes, and ways to manage it. This article provides a comprehensive guide on the concept of systemic risk.

• Table of contents

1. What is systematic risk?
2. Types of systematic risk
3. Calculation of systematic risk (β)
4. The significance of systematic risk
5. Example of systematic risk
6. Causes of systematic risk
7. Tips for mitigating systematic risk
8. Relationship between beta and systematic risk

What is systematic risk?

Systematic risk refers to the risk inherent to the entire market or system. Also known as 'undiversifiable risk' or 'market risk'––systematic risk affects the overall market, not just a particular stock or industry.

For example, events like recessions, wars, political instability, changes in monetary policy, etc. can lead to a market-wide downturn and impact a large number of stocks across sectors. Since these risks cannot be mitigated through diversification, they are termed systematic risks.

On the other hand, unsystematic risks are specific to a company or industry. These can be minimised or mitigated through diversification, whereas systematic risk exposure remains even in a highly diversified portfolio.

Types of systematic risk

• Macroeconomic risks - Risks arising from macroeconomic conditions and policies like inflation, deflation, economic growth, fiscal and monetary policies, etc. For instance, high inflation typically leads to a market decline.
• Geopolitical risks - Threats arising from political events like regime change, wars, terrorist attacks, etc. Geopolitical tensions often spur market volatility.
• Currency risks - Fluctuations in foreign exchange rates impact companies' overseas revenues and input costs. A rising domestic currency makes exports less competitive.
• Natural disasters - Extreme events like earthquakes, floods, and storms that disturb business operations regionally or nationally introduce market risk.
• Pandemics—Health crises like the COVID-19 pandemic disrupt supply chains and demand across sectors, causing markets to contract.
• Liquidity risk - Difficulty in trading securities due to low market liquidity leads to high volatility and risk. Liquidity issues tend to have market-wide impact.

Read Also: Understanding systematic and unsystematic risks in large cap mutual funds

Calculation of systematic risk (β)

In investment analysis, systematic risk is measured statistically using beta (β). Beta gauges a stock or portfolio's volatility in relation to the overall market.

The beta coefficient is calculated as follows

β = Covariance (Asset returns, Market returns) / Variance (Market returns)

Here, covariance measures how two variables move together historically. If returns on an asset and the market move in the same direction, the covariance is positive. A negative covariance means the returns move in opposite directions.

Variance captures how far the market returns deviate from the mean. The greater the variance, the higher the market volatility.

Beta quantifies the tendency of an asset or portfolio to respond to swings in the overall market.

• Beta of 1 indicates the stock or fund moves in sync with the market.
• Beta above 1 is more volatile than the market.
• Beta below 1 is less volatile.
• Negative beta means the asset moves opposite to markets.

The significance of systematic risk

• Market declines - High systematic risk means the stock will experience larger losses in a market downturn.
• Diversification - Systematic risk cannot be mitigated through diversification within one market. Combining assets from different markets may help lower systematic risk.
• Required returns - Investors demand higher returns from assets with greater systematic risk. Stocks with high betas need to offer higher potential returns.
• Asset valuation - Models like the Capital Asset Pricing Model account for systematic risk via beta when valuing assets. Stocks with higher betas have lower valuations.
• Performance measurement - Systematic risk impacts how fund manager performance is analysed vis-à-vis the benchmark. Managers are evaluated based on their portfolio's beta.

Example of systematic risk

The global financial crisis of 2008 illustrates systematic risk and its market-wide impact spanning various countries, sectors, and asset classes.

Even fundamentally strong stocks across industries fell sharply due to panic selling and flight to safety. Investor losses were widespread and indiscriminate.

Such severe market impact highlights the prevalence of systematic risk factors like credit contraction, subprime mortgage crisis, and economic recession.

The crisis led to systematic changes in the United States like stricter bank regulation and central bank policy amendments to counter market risk exposure. For investors, the events emphasised the need for caution and diversification during periods of high systematic risk.

Causes of systematic risk

• Investor behavior - Investor sentiment and psychology significantly sway markets. Market exuberance or panic leads to volatility spikes.
• Leverage - Widespread use of leverage exaggerates market movements when investors are forced to cut positions suddenly.
• Economic bubbles - Overvaluations and bubbles in assets like housing and dotcom stocks fuel systematic risk. Their inevitable bursting leads to crises.
• High-frequency trading - Algorithmic and high-speed trading by large institutions can trigger flash crashes through cascading sell-offs.

Tips for mitigating systematic risk

While systematic risk exposure cannot be entirely avoided, prudent strategies can help investors manage it.

• Increase cash allocation - Raising cash reserves provides a buffer against market declines driven by systematic risk events.
• Hedge with derivatives - Strategic hedging using derivatives like put options, futures and swaps helps lower portfolio risk.
• Favour defensive stocks - Choose stocks like consumer staples and utilities that hold up better during market selloffs.
• Rebalance portfolio - Rebalancing forces investors to buy low and sell high consistently, avoiding overexposure when systematic risk is high.

Relationship between beta and systematic risk

Beta indicates a stock's systematic risk relative to the overall market portfolio. Stocks with higher beta tend to experience larger price swings than the market when systematic risk events occur.

Some key aspects of the beta-systematic risk relationship are below.

• Beta above 1 signals higher systematic risk than the average stock. As the market declines, high beta stocks fall farther than market.
• Conservative stocks like utilities with low betas are less impacted by market downturns driven by systematic factors.
• Negative beta stocks actually benefit from rising systematic risk and move opposite to markets. For instance, gold acts as a hedge during crises.
• Diversification aims to lower portfolio beta and reduce susceptibility to market volatility stemming from systematic risks.
• Index funds directly take on the market's systematic risk with betas very close to 1. In contrast, active funds attempt to hold less systematic risk.
• During bull runs, high beta stocks outperform as markets rise. But investors assume higher systematic risk.

Conclusion

Systematic risk exposes the entire market to potential shocks and volatility. As opposed to risks specific to individual assets, systematic risk cannot be mitigated through diversification alone. Often originating from macroeconomic and geopolitical factors, systematic risk requires active measurement and management.

Also Read : Balancing act: Exploring the relationship between risk and return in mutual fund

FAQs

What is called systematic risk?

Systematic risk is the inherent risk that affects the entire market or a broad segment of it, making it unavoidable through diversification. It arises from macroeconomic factors like inflation, interest rates, or geopolitical events.

What are the 5 systematic risks?

The five key types of systematic risk include market risk, interest rate risk, inflation risk, currency risk, and geopolitical risk. These risks impact the overall financial system rather than specific industries or companies.

Which is the best example of systemic risk?

A major financial crisis, like the 2008 Global Financial Crisis, is a prime example of systemic risk. It triggered widespread market failures, economic downturns, and government interventions worldwide.

What is the difference between systematic risk and specific risk?

Systematic risk affects the entire market and cannot be mitigated through diversification, while specific (unsystematic) risk is company- or industry-specific and can be reduced by holding a diversified portfolio. Examples include economic recessions for systematic risk and a company’s management failure for specific risk.

Is credit risk systematic or unsystematic?

Credit risk is generally considered an unsystematic risk because it pertains to the possibility of a specific borrower defaulting. However, during financial crises, it can become systematic when widespread defaults impact the entire financial system.

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