Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Systematic Risk

What it is:

Also called market risk or non-diversifiable risk, systematic risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets.  

Unsystematic risk is the risk that something with go wrong on the company or industry level, such as mismanagement, labor strikes, production of undesirable products, etc.

Systematic risk + Unsystematic risk = Total risk

How it works (Example):

Systematic risk is comprised of the “unknown unknowns” that occur as a result of everyday life. It can only be avoided by staying away from all risky investments.

 

Systematic risk can also be thought of as the opportunity cost of putting money at risk.

 

For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of Deposit. Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index. If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky equity investment.

 

The most basic strategy for minimizing systematic risk is diversification. A well-diversified portfolio will consist of different types of securities from different industries with varying degrees of risk. The unsystematic risks will offset one another but some systematic risk will always remain.

Why it Matters:

Because of market efficiency, you will not be compensated for the additional risks that arise from failure to diversify your portfolio. This is extremely important for those who may have a large holding of one stock as part of an employer-sponsored incentive plan. Unsystematic risk exposes you to adverse events on a company or industry level in addition to adverse events on a global level.

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