Systematic risk: what investors need to know

Key takeaways

• Systematic risk is associated with all offerings across a market, while unsystematic risk is typically stock, or industry specific. 

• Factors that can trigger systematic risk include interest rate changes, inflation, and unfavorable exchange rate changes, while unsystematic risks are triggered by industry-specific regulatory changes, the sudden emergence of a formidable competitor, product recalls and illegal activities. 

* Alternative investments tend to be less correlated with public equities, and thus can offer protection against both systematic and unsystematic risks.

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One of the most important things for investors to understand is that risk is inherent to the process of investing. The most pervasive, otherwise known as systematic risk, can be triggered by a number of different factors. These include economic, socio-political, and market-related occurrences. Also referred to as market risk, diversification does little to mitigate it, because of its all-encompassing nature. However, it can be managed and potentially reduced with the right investment strategies. Here is what investors need to know about systematic risk.

What is Systematic Risk?

Systematic risk most often results from recession, economic weakness, international conflict, rising or stagnate interest rates, currency fluctuation or volatile commodity prices. As mentioned above, diversification within publicly traded equities or fixed income products does little to resolve this type of risk, because it affects the financial market as a whole. 

Types of Systematic Risk

The five main types of systematic risk include market risk, interest rate risk, purchasing power/inflation risk, and exchange rate risk. 

Market risk functions like a string of dominoes in that the tipping of one can cause others to topple. Investors tend to follow the movements of the market. In other words, as investors respond to supply and demand, the prices of securities tend to move in lockstep. In a declining market, prices fall and investors rush to sell. This only serves to make prices fall further, even if the fundamentals of a company are sound. Mired in a falling market, its value tumbles right along with the rest of the market.

Interest rate risk results from the ebbs and flows of market interest rates. Fixed income products are most vulnerable to this type of systematic risk because their values are tied directly to prevailing interest rates. Bond prices fall when market interest rates go up and they advance when interest rates decline. Interest rate risk also plays a role in price risk and reinvestment risk. Price risk results from changes in the value of a security in response to interest rate changes.

Inflation is a persistent and sustained increase in general prices. Purchasing power is severely inhibited during periods of inflation, which typically results from a larger number of dollars chasing a shortage of goods. In situations in which incomes remain stagnant as prices increase, the value of a dollar diminishes, as does the return on an invested dollar. Inflation risk can be particularly troubling for fixed income assets.

Exchange rate risks arise from uncertainties triggered by global events. The currencies of other nations can fluctuate due to a number of causes, including war, devaluing of natural resources, or political turmoil. In such instances, exchange rate risk can have a negative impact on the value of securities in companies that depend heavily on foreign transactions.

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Unsystematic Risk

Rather than the market as a whole, unsystematic risk affects individual companies or industries. For example, the current push toward electrification of transportation has the potential to be detrimental to the petroleum industry. 

As a hedge against this danger, oil companies are raising prices significantly. However, this is an unsustainable solution, in that the effect of this approach has the potential to drive the migration to electric cars more rapidly. Other examples of unsystematic risk include industry-specific regulation changes, the sudden emergence of a formidable competitor, product recalls, illegal activities, labor issues or the nationalization of a company.

Owners of securities in companies affected in this manner will experience adverse changes at some point in the future. However, unlike systematic risk, diversification can work as a shield against unsystematic risk. Investors need only be careful to ensure their portfolios contain securities capable of mitigating any downturn in the affected stocks until they can shift out of them.

Risk Compensation

Given risk is inherent to investing, there must be some reward for taking it on. Moreover, diversifying away from systematic risks, while staying in the public markets, can be difficult, if not impossible to achieve. Therefore, the more significant a risk an investor is willing to take, the greater the potential reward (in most cases) will be for taking it on. This compensates investors for assuming the systematic risks that go along with investing, which makes it good risk, as opposed to bad risk.

Unsystematic risks however, can be readily mitigated with diversification; therefore it’s considered a bad risk. The risks of individual stock ownership can easily be diversified away by owning a passive asset class or an index fund tracking all of the stocks in an asset class. Therefore, this is considered a bad risk and the compensation for taking it on is generally less significant.

Alternative Investments and Risk Management

Asset classes such as real estate, private equity, venture capital, digital assets and collectibles are among those designated as “alternative investments.” While they are hard to define, broadly speaking, they tend to be less correlated with public equity, and thus can offer potential for diversification. 

While traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation, a more balanced 60/20/20 or 50/30/20 split incorporating alternatives may make a portfolio less sensitive to public market short-term swing resulting from the various risk factors. 

However, these assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums – often between $500,000 and $1 million.  Yieldstreet was founded with the goal to dramatically improve access to alternative assets by making them available to a wider range of investors. 

Alternative investments can be a hedge against both systematic and unsystematic risk, because of their low correlation to the markets in general. In many cases, issues such as inflation for example can make some alternative investments such as real estate — more valuable.

Still, risk is a part of the natural order of investing. All investment entails risk. The key for investors is to understand those risks and how they relate to their overall goals. 

Learn more about the ways Yieldstreet can help diversify and grow your portfolio.

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