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Systematic Risk

Guide to Understanding Systematic Risk

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Systematic Risk

Systematic Risk Definition (Market Risk)

Systematic risk, often referred to as “market risk”, represents a potential risk to the broader economy and entire financial system.

Because of the far-reaching scope of systematic risk—wherein the entire economy is placed in a vulnerable position—portfolio diversification cannot mitigate this risk.

Of course, the severity of the risk is not spread evenly across all sectors, as some are able to recover and return to normalcy more quickly.

In contrast, other companies are not as fortunate and can suffer steep monetary damages that are irreparable, i.e. a company in financial distress could likely file for bankruptcy protection and either undergo a reorganization (Chapter 11) or liquidation (Chapter 7).

Causes of Systematic Risk

The causes of systematic risk are largely in part related to macroeconomic events, where a domino effect is frequently observed in the global financial system.

The following list outlines examples of external events that represent sources of systematic risk.

  • Global Recessions
  • Geopolitical Risk
  • Global Pandemics
  • Natural Disasters
  • Monetary Policies (Inflation)
  • Currency Crashes

Systematic Risk vs. Unsystematic Risk: What is the Difference?

In corporate finance, the concept of risk that impacts the public equities market is segmented into two distinct categories.

  1. Systematic Risk → Non-Diversifiable Risk
  2. Unsystematic Risk → Diversifiable Risk

Systematic risk impacts the entire financial market and economy as a whole, whereas unsystematic risk is specific to a company (or security).

Understanding the distinction between systematic and unsystematic risk is critical with regard to risk management and reducing the potential for incurring monetary losses, not only for market participants such as investors, but also society as a whole.

Unsystematic risk, contrary to systematic risk, can indeed be mitigated through portfolio diversification, i.e. allocating capital strategically across different sectors with minimal correlation to one another.

Given the unpredictable nature of such external events, many are termed “Black Swan Events”, which allude to rare, uncommon events with a very low probability of occurrence. Yet the long-term consequences of these types of events can be profound on the lives of consumers and businesses for years thereafter.

Dot-Com Bubble Example: Stock Market Collapse (2001)

For example, the dotcom bubble of 2001 is considered an event reflecting systematic risk. After a long period of strong economic growth propelled by tech companies, the economy catastrophically collapsed once the Internet bubble “popped”.

The effects of the dot-com bubble led to trillions of dollars in market cap being wiped out as tech companies with inflated valuations folded. The sudden collapse shocked the entire financial markets, resulting in an economic recession.

But while the dot-com bubble exposed the tech companies with minimal market traction and unjustified valuations, many of the leading companies as of the present date were those that managed to emerge post-collapse. Most notably, Amazon.com (Nasdaq: AMZN) was able to survive the market crash, in which its share price was down >90% at one point. But the e-commerce retailer was able to weather the storm and become one of the first companies to hit a market capitalization over $1 trillion in 2020.

Systematic Risk Examples: Covid-19 Pandemic

One example of an external risk that impacted the entire global financial system was the Covid-19 pandemic.

While not the first highly-transmissible pathogenic virus, the sudden outbreak of SARS-CoV-2 around late 2019 was an unanticipated event that even regulatory bodies such as the CDC and WHO seemed unprepared for.

Soon after, the pandemic led to mandatory mask mandates and global lockdowns as countries frantically attempted to reduce their infection rates and contain the spread of the virus.

Throughout the lockdown period, government mandates placed measures in which businesses were forced to close shop and were unable to operate normally.

Close to all publicly-traded securities were exposed to systematic risk, but an important point here is that a clear disconnect formed between the economy and the public markets.

While small businesses were struggling and many went bankrupt even with governmental aid, the share prices of many public companies, despite reporting weak financial performance, were upheld.

The general sentiment was that the temporary underperformance would subside, and this optimism was aided by the rock-bottom yields exhibited in the bonds market.

Drastic monetary policies were also implemented, such as the U.S. Fed flooding the capital markets with money to calm investors down and prevent a free fall in the financial markets as part of the crisis control.

The decisions of the Fed and those made by the central banks of other countries, continue to be scrutinized, and the long-term effects to the global financial system are still relatively unknown.

As countries gradually recover and ease their aggressive monetary policies, the consequences are likely to materialize in the coming years. In fact, inflation from the decisions to cut interest rates and print a seemingly endless amount of money are currently major issues in many countries like the U.S.

How is Systematic Risk Measured? (Beta and CAPM)

The most common measure of systematic risk is the concept of beta (β), which reflects sensitivity of an individual security (or portfolio of securities) to market risk, i.e. the market volatility relative to the broader market (S&P 500).

The capital asset pricing model (CAPM) calculates the expected return on a security given three inputs:

  1. rf → Risk Free Rate
  2. B → Beta
  3. Equity Risk Premium (rm – rf) → Market Return Less Risk Free Rate

The capital asset pricing model (CAPM) formula is as follows.

Expected Return (ke) = rf + β × (rm – rf)

Beta, the risk component in the CAPM, establishes the relationship between the market risk and the expected return. Under the CAPM, the expected return on a security is a function of the systematic risk, rather than the unsystematic risk, as the latter can be diversified.

For individual securities or a portfolio, the beta coefficient is estimated by regressing the historical returns of a security to the returns on a stock market index, typically the S&P 500.

The beta of the broader equities market, at all times, is equal to one, so a coefficient of 1 implies the security’s systematic risk is equivalent to the systemic risk of the stock market on average.

  • Higher Beta Coefficient → Higher Market Risk (Volatility)
  • Lower Beta Coefficient → Lower Market Risk (Volatility)

If the beta of a security is greater than 1, then the expected return is higher to compensate the investor for the greater market volatility risk (and vice versa).

In closing, while systematic risk might not be able to be diversified away, the efficient allocation of capital into different asset classes and commodities such as gold (i.e. which bears negative beta), simply deciding to hold cash, and hedging strategies such as short selling can serve to mitigate this risk.

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