Systematic risk, also known as market risk or undiversifiable risk, refers to the inherent risk that affects the entire market or a broad segment of the market. Unlike unsystematic risk, which is specific to a particular company or industry, systematic risk cannot be eliminated through diversification. It is influenced by factors such as economic changes, political events, natural disasters and anything else that impacts the overall market.

What is Systematic Risk?

Systematic risk arises from external factors that affect the entire market. These factors can include changes in interest rates, inflation, recessions, political instability, and global events. Because these risks are pervasive, they impact all investments to some degree, making it impossible to completely avoid them through diversification.

Examples of Systematic Risk

  1. Global Financial Crisis (2008) The 2008 global financial crisis is a prime example of systematic risk. Triggered by the collapse of major financial institutions and the bursting of the housing bubble in the United States, the crisis led to a severe economic downturn that affected markets worldwide. Stock prices plummeted, credit markets froze, and economies entered recessions. Investors across the globe experienced significant losses, regardless of the specific assets they held.

  2. COVID-19 Pandemic (2020) The COVID-19 pandemic is another example of systematic risk. The outbreak of the virus led to widespread lockdowns, disruptions in supply chains, and a sharp decline in economic activity. Global stock markets experienced extreme volatility, with major indexes like the S&P 500 and Dow Jones Industrial Average seeing significant drops. The pandemic’s impact was felt across all sectors, highlighting the pervasive nature of systematic risk.





Key Takeaways

  1. Generally to be Avoided While systematic risk cannot be completely avoided, investors can take steps to mitigate its impact. The wrong approach in my estimation is to maintain a diversified portfolio that includes a mix of asset classes, such as stocks, bonds, and real estate. This can help reduce the overall risk exposure.  I say that because while a truly diversified portfolio reduces risk, it also mutes returns.

  2. Deploy a Strategy That Works in Sideways Markets In times of market uncertainty, it is crucial to deploy strategies that can withstand systematic risk. For example, trading in defensive stocks, such as utilities and consumer staples, can provide more stability during economic downturns. Additionally, using hedging techniques, such as options and futures, can help protect against market volatility.

  3. Wait for a Breakout In timing the market, traders may want to wait for clear signals of a market breakout before making significant risk exposure. This approach can help avoid the pitfalls of missing short-term market fluctuations.

Conclusion

Systematic risk is an unavoidable aspect of trading that affects the entire market. By understanding its nature and implementing strategies to mitigate its impact, traders can better navigate the uncertainties of the financial markets. Remember, while you can’t eliminate systematic risk, you can manage it effectively to achieve your trading goals.