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.
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
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.
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:
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.
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/