When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
How to include systematic risk analysis in your investments
Systematic risk has huge implications for your wealth and demands close attention. In essence, it refers to the risk that pervades the entire economy and all financial markets - meaning it affects every investor.
Unsystematic risks can be diversified through portfolio management techniques, but systematic risks cannot be fixed with diversification because it affects all investments.
This article will explore systematic risk in-depth, including its sources and effects on investment outcomes. The aim is to equip you with the knowledge and skills to navigate this critical investment risk component successfully.
Unsystematic risks can be diversified through portfolio management techniques, but systematic risks cannot be fixed with diversification because it affects all investments.
This article will explore systematic risk in-depth, including its sources and effects on investment outcomes. The aim is to equip you with the knowledge and skills to navigate this critical investment risk component successfully.
Big ideas
- Investing involves risk, which can be divided into systematic and unsystematic risk.
- Systematic risk affects the entire market equally, while unsystematic risk affects only specific companies or industries.
- Systematic risk cannot be diversified away, but it can be insured against by hedging using options or other derivatives.
- The equity risk premium compensates investors for taking on systematic risk, and beta is a way to measure a stock's exposure to systematic risk.
Investing is a risky business
Walking down the street, flying in a plane, getting out of the bathtub: no matter how you look at it, life is full of risks. And investing is no different. How often have you seen a disclaimer on a commercial or website saying something to the effect of “all investments are speculative in nature and involve risk.”
It’s common sense, right? If you’re even somewhat familiar with capital markets, you know there’s no such thing as a sure bet; if someone approaches you “guaranteeing” returns, run away as fast as you can. The uncertainty (or lack of guarantee) in investing is the risk you must take.
It’s common sense, right? If you’re even somewhat familiar with capital markets, you know there’s no such thing as a sure bet; if someone approaches you “guaranteeing” returns, run away as fast as you can. The uncertainty (or lack of guarantee) in investing is the risk you must take.
Unlike walking down the street or getting out of the bath, market risk is somewhat easier to define, if not predict. Broadly, we break investment risks into two categories: systematic risk and unsystematic risk.
Both systematic and unsystematic risks have several synonyms. We’ll list them for reference, but this article only uses these two terms.
Systematic risk, also known as:
Both systematic and unsystematic risks have several synonyms. We’ll list them for reference, but this article only uses these two terms.
Systematic risk, also known as:
- Market risk
- Undiversifiable risk
- Volatility, or volatility risk
Unsystematic risk also goes by:
- Idiosyncratic risk
- Diversifiable risk
- Company risk (or industry risk)
- Marginal/residual risk
Astute investors can likely infer the meaning of each by their synonyms, but we’ll dig into the full details of systematic and unsystematic risk.
What is a systematic risk?
Systematic vs unsystematic risk
Systematic risk affects the entire market - in general, no one escapes untouched.
Unsystematic risk is narrower in scope and affects only a single company or industry. For example, increased oil production in the Middle East could hurt US oil and gas stocks, but the broad market remains unaffected.
Unsystematic risk is narrower in scope and affects only a single company or industry. For example, increased oil production in the Middle East could hurt US oil and gas stocks, but the broad market remains unaffected.
That’s the core of what makes up unsystematic risk and systematic risk. As always, though, the details are much more expansive and nuanced as you dig a little deeper.
Capital market theory, the underpinning of stock market management and investing, breaks risk into two baskets: systematic risk and unsystematic risk. Systematic risk is everything on a national and, increasingly, global scale that affects the entire market equally and all stocks within that market.
Capital market theory, the underpinning of stock market management and investing, breaks risk into two baskets: systematic risk and unsystematic risk. Systematic risk is everything on a national and, increasingly, global scale that affects the entire market equally and all stocks within that market.
Total portfolio risk
Think of all the factors that shook the markets in the past 20 years. The 2008 Great Financial Crisis, the pandemic's beginning, and the effects of global interest rate hikes in 2022 are just three types of systematic risk, but many more are imaginable.
Natural disasters, geopolitical conflict, and devastating financial events like bank collapses are some of the main causes of systematic risk. Systematic risk events are increasingly globalised as our national interests become increasingly intertwined, and technology enables a seemingly-tiny event’s ramifications to be felt worldwide.
Like bank collapses that start with a run on a regional system and whose small aftershocks turn into a global earthquake, systematic risk, in simple words, is the risk that’s unavoidable, unshakeable, and touches everyone.
Natural disasters, geopolitical conflict, and devastating financial events like bank collapses are some of the main causes of systematic risk. Systematic risk events are increasingly globalised as our national interests become increasingly intertwined, and technology enables a seemingly-tiny event’s ramifications to be felt worldwide.
Like bank collapses that start with a run on a regional system and whose small aftershocks turn into a global earthquake, systematic risk, in simple words, is the risk that’s unavoidable, unshakeable, and touches everyone.
Diversification to minimise unsystematic risk
If you’re investing for the long haul and want to maintain stability in your portfolio, you diversify by spreading your money amongst many stocks or ETFs.
Diversification helps prevent bad news for one company (unsystematic risk) overly affecting your entire portfolio. Investing in, for example, healthcare, the defence industry, and technology stocks means trouble in one sector isn’t the end of your entire portfolio.
Systematic risk cannot be diversified away. We’ll cover alternative strategies to protect against systematic risk soon but since systematic risk affects all stocks within a market, there’s no way to invest in a different industry, company, or sector that’s unaffected by systematic risk.
We’ll also explore some examples of systematic risk, but think of what happened at the beginning of the pandemic - stocks fell across the board, and an asset wasn’t available to diversify that systematic risk.
Diversification helps prevent bad news for one company (unsystematic risk) overly affecting your entire portfolio. Investing in, for example, healthcare, the defence industry, and technology stocks means trouble in one sector isn’t the end of your entire portfolio.
Systematic risk cannot be diversified away. We’ll cover alternative strategies to protect against systematic risk soon but since systematic risk affects all stocks within a market, there’s no way to invest in a different industry, company, or sector that’s unaffected by systematic risk.
We’ll also explore some examples of systematic risk, but think of what happened at the beginning of the pandemic - stocks fell across the board, and an asset wasn’t available to diversify that systematic risk.
Why invest at all if there’s a constant threat of unpredictable, unavoidable, and non-diversifiable risk? “Risk-free” investments, like high-quality government debt (UK, US, and similar countries’ bonds) exist and represent an almost guaranteed return.
The equity risk premium is why it’s worth investing in the stock market despite the uncertainty. It represents how investors are rewarded for systematic risk. The equity risk premium is the difference between the overall stock market’s returns and what you’d get for only investing at the risk-free rate.
The equity risk premium is why it’s worth investing in the stock market despite the uncertainty. It represents how investors are rewarded for systematic risk. The equity risk premium is the difference between the overall stock market’s returns and what you’d get for only investing at the risk-free rate.
Market risk premium
The equity risk premium is also called the market risk premium because it is the investors’ reward for investing in the overall market. The mechanics of calculating an equity risk premium are beyond our scope, but the final formula is:
FORMULA
Equity Risk Premium = Expected Market Returns - Risk-Free Rate
What’s the difference between systemic vs. systematic risk?
Systemic risk is the risk that an event will trigger a cascade of events that will have a negative impact on the stability of the financial system. Systematic risk is the risk that will affect the entire market, so it cannot be diversified away.
When we refer to a specific incident, we mean systemic risk. We covered global bank collapses as an example of systematic risk, but the single bank run itself that triggered global collapse is the systemic risk.
Measuring systemic risk is difficult and irrelevant to most investors. Mostly done by banks themselves to measure their own systemic risk, the calculation comprises a series of insurance costs each bank carries to prevent their contribution to systemic risks.
When we refer to a specific incident, we mean systemic risk. We covered global bank collapses as an example of systematic risk, but the single bank run itself that triggered global collapse is the systemic risk.
Measuring systemic risk is difficult and irrelevant to most investors. Mostly done by banks themselves to measure their own systemic risk, the calculation comprises a series of insurance costs each bank carries to prevent their contribution to systemic risks.
Systematic risk is not the same as systematic investing. Instead, systematic investing means any system of investment that’s rigorously rule-based, like quantitative investing.
Systematic investing differs from discretionary investing, wherein you pick stocks based on your own criteria or preferences; systematic investing means investing in stock no matter what, so long as it meets a predefined rule defined by the investing system.
You’re likely already familiar with some systematic investment strategies, but they include any that depend upon data and algorithmic insights to pick stocks.
For example, if you have a model that says to invest in firms with over a $1B market cap the day after a 1% drop in the share price, then you’re practising a systematic approach. Models and methods vary widely in systematic investing and tend to be much more complicated than this simple example.
A primary benefit of systematic investing is that it cuts out the emotional side of human decision-making and forces you to follow the rules without second-guessing yourself.
Systematic investing differs from discretionary investing, wherein you pick stocks based on your own criteria or preferences; systematic investing means investing in stock no matter what, so long as it meets a predefined rule defined by the investing system.
You’re likely already familiar with some systematic investment strategies, but they include any that depend upon data and algorithmic insights to pick stocks.
For example, if you have a model that says to invest in firms with over a $1B market cap the day after a 1% drop in the share price, then you’re practising a systematic approach. Models and methods vary widely in systematic investing and tend to be much more complicated than this simple example.
A primary benefit of systematic investing is that it cuts out the emotional side of human decision-making and forces you to follow the rules without second-guessing yourself.
Some real-life examples of systematic risk
A great recent example of systematic risk is the beginning of the pandemic in 2020. No matter how diversified you were then, your entire equities portfolio was doubtlessly affected, although the degree varied based on industry or type of stock (i.e. healthcare stocks fell a lot less than cruise ship and hotel stocks).
Historical price charts used in this article are for educational purposes only. Past performance doesn’t guarantee future results.
Look at these three overlaid stock indices - in 2020, every index that measures markets globally saw substantial effects of systematic risk and paid the price:
Historical price charts used in this article are for educational purposes only. Past performance doesn’t guarantee future results.
Look at these three overlaid stock indices - in 2020, every index that measures markets globally saw substantial effects of systematic risk and paid the price:
What does beta mean in risk management?
Beta tells you how volatile a stock is compared to the overall market and is a way to measure systematic risk.
Although the equity risk premium tells you the overall reward for investing in the market and your exposure to systematic risk, you need a way to determine how much a specific stock or company is affected by systematic risk. The answer is an investment’s beta.
The market’s beta is always 1, in this case, represented by the S&P 500. If a stock is affected by systematic risk more than the broader market, its beta is greater than 1; if it’s more stable in the face of market-wide volatility, its beta is less than 1. It’s possible for assets to have a negative beta or go up when the market goes down, but it isn’t typical in reality - remember, systematic risk affects all assets to some degree, so seeing one rise when all others fall isn’t practical.
Although calculating a beta on your own is difficult without experience and an in-depth understanding of capital market theory, determining systematic risk with the beta is simple as the number is easily available in the Trading 212 app and elsewhere on the web:
Although the equity risk premium tells you the overall reward for investing in the market and your exposure to systematic risk, you need a way to determine how much a specific stock or company is affected by systematic risk. The answer is an investment’s beta.
The market’s beta is always 1, in this case, represented by the S&P 500. If a stock is affected by systematic risk more than the broader market, its beta is greater than 1; if it’s more stable in the face of market-wide volatility, its beta is less than 1. It’s possible for assets to have a negative beta or go up when the market goes down, but it isn’t typical in reality - remember, systematic risk affects all assets to some degree, so seeing one rise when all others fall isn’t practical.
Although calculating a beta on your own is difficult without experience and an in-depth understanding of capital market theory, determining systematic risk with the beta is simple as the number is easily available in the Trading 212 app and elsewhere on the web:
o use it, see whether the company’s beta is more or less than the market’s:
For example (as of March 2023):
For example (as of March 2023):
In this case, you see that AT&T is much less affected by systematic risk than Carvana, which makes sense. Even if there’s a market-wide shock caused by a systemic event, everyone still needs internet and mobile phone connectivity, so AT&T isn’t going anywhere. But, during risk events like the current downturn caused by rate hikes, Carvana (blue) is much more exposed to systematic risk and falls further, faster, and harder than the market itself, and even AT&T:
S&P 500 vs AT&T vs Carvana
This chart also shows the benefits of high-beta stocks less exposed to systematic risk: although both Carvana and AT&T (yellow) are affected by systematic risk in this chart, AT&T is much less extreme in its swings and could help stabilize a portfolio, although not diversify away the systematic risk.
Recent examples of unsystematic risk
Types of unsystematic risk are those that only affect a company or industry based on events unique to them rather than market-wide. As an example of unsystematic risk, consider any stock posting poor earnings. They’ll often fall considerably, especially if earnings underperformance isn’t expected, but that stock drop doesn’t usually affect most other stocks; the risk is unique to the company and thus unsystematic risk.
For example, retailer Gap Inc (GPS) reported poor earnings for Q4 2022, and the stock fell substantially on the news; however, the market itself was largely unaffected:
For example, retailer Gap Inc (GPS) reported poor earnings for Q4 2022, and the stock fell substantially on the news; however, the market itself was largely unaffected:
Earnings are an example of unsystematic risk. They don’t affect the market and are thus diversifiable. If your portfolio was only comprised of Gap stock on March 9th, 2023, when they reported poor earnings, your portfolio value would drop substantially. But if you diversified your portfolio with another stock reporting earnings in the same period that outperformed, in this case, Oracle (ORCL), the diversification would offset Gap’s negative effect on your capital.
Earnings are simply one type of unsystematic risk in investing; the examples of unsystematic risk are as endless as your imagination. Executive misconduct, strikes, oil prices, and train wrecks are all (but by no means the only) types of unsystematic risk.
Practical steps for risk management
We can diversify unsystematic risk, but now we know that we can’t do the same if it’s systematic. Then how can you, as an investor, manage systematic risk?
Systematic risk is insurable. This means that you can take certain actions to protect yourself in the event of something that affects the market as a whole, much as you buy insurance against the possibility of a car accident or natural disaster destroying your home.
Options are a common way to insure against systematic risk.
Systematic risk is insurable. This means that you can take certain actions to protect yourself in the event of something that affects the market as a whole, much as you buy insurance against the possibility of a car accident or natural disaster destroying your home.
Options are a common way to insure against systematic risk.
Stock options
Call options give the owner the right to buy a stock at a certain price (strike) at a set date. For example, if you have one SPY call stock option dated January 1st, 2024, at $400, you can buy the stock at that price in January 2024; it’s beneficial if you expect the stock to exceed that price.
Put options let you sell your existing stock if it’s below the strike price by the expiration date and is a way to insure against both unsystematic risk, by buying puts on your specific stocks, or market risk if you buy puts on a market index.
Put options let you sell your existing stock if it’s below the strike price by the expiration date and is a way to insure against both unsystematic risk, by buying puts on your specific stocks, or market risk if you buy puts on a market index.
Although options are designed to insure against your actual stock, you can also buy and sell options as an insurance strategy on your own.
For example, if you wanted to insure against systematic risk as measured by the S&P 500, you could buy SPY puts that would increase in value as SPY fell. Likewise, you could buy calls or ETF shares for an index that measures volatility; a prime example is the VIX index. Known as “Wall Street’s Fear Gauge,” the VIX measures volatility and tends to increase as systematic risk pushes stocks down. As we see from the chart below, VIX can insure against systematic risk because it rises as the S&P 500 falls and falls as stocks rise. Peaking at the bottom of the market in 2020, insurance with the VIX may have offset systematic risk in your portfolio if you had sufficient holdings of a VIX ETF.
For example, if you wanted to insure against systematic risk as measured by the S&P 500, you could buy SPY puts that would increase in value as SPY fell. Likewise, you could buy calls or ETF shares for an index that measures volatility; a prime example is the VIX index. Known as “Wall Street’s Fear Gauge,” the VIX measures volatility and tends to increase as systematic risk pushes stocks down. As we see from the chart below, VIX can insure against systematic risk because it rises as the S&P 500 falls and falls as stocks rise. Peaking at the bottom of the market in 2020, insurance with the VIX may have offset systematic risk in your portfolio if you had sufficient holdings of a VIX ETF.
You cannot follow all three Ds of investing (discipline, diversification, and dividends) exclusively by insuring against systematic risk, but you can easily practice disciplined risk management and fulfil one of the three criteria.
FAQ
Q: Why is systematic risk important to investors?
Systematic risk is important to investors because it represents a permanent threat to their portfolio, capital, and net worth. Systematic risk is unpredictable and affects the entire market to some degree, if not equally.
Systematic risk is important because it is non-diversifiable, meaning one company’s stock won’t offset losses during a systematic risk event. Systematic risk is insurable, though, and you can buy options or take advantage of other derivatives to offset systematic risk, although these methods aren’t guaranteed to work.
Systematic risk is important because it is non-diversifiable, meaning one company’s stock won’t offset losses during a systematic risk event. Systematic risk is insurable, though, and you can buy options or take advantage of other derivatives to offset systematic risk, although these methods aren’t guaranteed to work.
Q: What are factors of systematic risk?
Systematic risk factors vary and include natural disasters, rate hikes, geopolitical conflict, and war - nearly anything and everything that can and does affect global markets.
Q: How are investors compensated for systematic risk?
Instead of investing in a risk-free asset, like high-quality government securities, investors demand additional compensation for systematic risk. This is called the equity risk premium and represents the difference between a market’s returns and the risk-free return.
Q: What are two sources of unsystematic risk?
Sources of unsystematic risk are even more varied than systematic risk. Since unsystematic risk is something affecting a single company or industry, simply imagine any news item you saw recently that led to a stock falling in price. Poor earnings and bad behaviour from management are just two sources of unsystematic risk, but there are as many more.
Q: Why would an investor ignore unsystematic risk?
Much like an equity risk premium for markets and systematic risk, investors demand extra compensation for a greater degree of unsystematic risk. Riskier stocks, therefore, may generate greater returns. Think of any small biotechnology stock - their unsystematic risk is driven by government health regulation and approval, which is unique to them, but they can give investors huge returns in exchange for risk if their drug or method is approved.
Beginner’s guide to diversification in investing
S&P 500 index: Using indices for investing
Investment returns: balancing risk & reward
