Managing your exposure to risk is an important aspect of investing. Every type of investment carries some degree of risk, and reducing your exposure to the factors that can negatively impact your investment capital could be the difference between red or black ink on your balance sheet.
Risk is broadly defined in two ways: systematic and unsystematic risk. In this article we’ll take a closer look at each so investors can gain a clearer understanding of risk factors that are beyond their control and those they can attempt to manage.
What Is Systematic Risk
Anyone who makes financial investments exposes their capital to systematic risk since systematic risk factors are outside of investor control. Systematic risk includes political, economic, sociological and other external factors that investors and organizations simply cannot strategize against, although they can make investments while keeping the potential impact of these factors in mind.
Systematic risk can be broken down into a few main categories:¹
- Market risk. This is by far the largest aspect of systematic risk. Investors typically follow the rise and fall of public equities markets. When markets are in bear territory, share prices of strong-performing companies still end up falling. Market risk, therefore, describes the relationship between investor mentality and the changes in share prices – the two move synchronously.
- Interest rate risk. Interest rate risk is caused by changes in interest rates and has the most impact on fixed-income securities since bonds are inversely tied to market interest rates.
- Inflation risk. Inflation brings increased risk because it erodes the purchasing power of your investment capital. Inflation risk, also called purchasing power risk, also adversely affects fixed-income securities since they have a fixed nominal value.
- Reinvestment risk. This type of risk refers to the potential for market interest rates to decrease after you have received income from your investments, which leads to an inability to reinvest that cash at a comparable rate of return.
Other factors that can be included in systematic risk are events that can’t be controlled, such as a global pandemic, destructive weather events or natural disasters, wars, or a recession. Regardless of how well you’ve crafted a diversified investment portfolio, these factors likely will adversely affect your investments.
What Is Unsystematic Risk
Unlike their counterparts described above, unsystematic risk factors don’t affect investments and markets as a whole. Unsystematic risk is also called diversifiable risk because portfolio diversification is one of the main ways investors can attempt to manage this type of risk. If systematic risk is the trunk of the tree, think of unsystematic risk as the branches. You can’t just cut the tree down, but you can prune certain branches in an attempt to make the tree healthier.
A few of the primary unsystematic risk factors include:
- Financial risk. This type of risk refers to a company’s debt load – highly leveraged firms have a higher degree of financial risk than those with less debt.
- Business risk. Many different factors can create business risk. A nationwide switch to electric vehicles, for example, could impact the auto and fuel industries. Increased competition, disruptive technologies, changing consumer preferences, demand and similar factors all can increase business risk.
- Liquidity risk. This risk factor describes the inability of an investor or organization to meet short-term debt requirements.
What Is Systemic Risk
There’s a third risk term we’ll briefly mention. Systemic risk, not to be confused with systematic risk, describes the likelihood of an event causing severe economic collapse. Systemic risk was a major contributor to the Great Recession that occurred during late 2007 through 2009.
Here’s an excellent example of systemic risk: When global financial services firm Lehman Brothers filed for bankruptcy in September of 2008, it roiled the financial markets and shut down capital markets. The widespread financial impacts of Lehman Brothers bankruptcy – the largest ever in the U.S. – directly led to the $180 billion Federal Reserve bailout of finance and insurance corporation AIG to avoid creating similar problems with AIG trading partners Merrill Lynch, Goldman Sachs and Morgan Stanley.
The Bottom Line
Systematic risks are caused by macro environmental, economic, technological, political and natural external factors that can roil public markets and disrupt the national economy – the pandemic is a perfect example. Unsystematic risk, meanwhile, takes place at the microeconomic level and can disrupt individual investors or organizations. Investors can attempt to manage unsystematic risk through portfolio diversification.
Sources:
1. Systematic Risk, Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/knowledge/finance/systematic-risk/
