What is systematic risk?

Systematic risk is the overall risk that is inherent to the financial market or a whole sector and is not specific to individual stocks. It is the risk investors take on by investing their wealth in the market, rather than keeping it in cash.

In economics, systematic risk is also known as undiversifiable risk, as it cannot be avoided through diversification across sectors if an entire financial market crashes.

Where have you heard of systematic risk?

You have likely come across the concept of systematic risk along with the other forms of risk investors should be aware of when starting out. Awareness of risk is important in building your portfolio and deciding how much of your wealth to invest.

What do you need to know about systematic risk?

Systematic risk differs from systemic risk, in that the latter refers to a specific unforeseen event that disrupts the global economy – for example, the Covid-19 pandemic – while a systematic risk refers to common factors that drive volatility. A systematic risk example would be a global recession that causes stock markets to fall.

There are several types of systematic risk that affect financial markets:

• Inflation risk

• Interest rate risk

• Market risk

• Currency risk

• Political risk 

You can also define systematic risk in relation to unsystematic risk, which refers to the risk inherent in certain sectors rather than the entire market. Investors can diversify their portfolio with equities from a variety of sectors to mitigate unsystematic risk.

While systematic risk is undiversifiable, investors can manage the risk by holding a range of asset classes, including stocks, bonds, real estate and cash savings, as their returns will vary if there is a major systematic change.

It is important to know how to calculate systematic risk. You can calculate the systematic risk for your portfolio by taking into account the beta (β) coefficient and standard deviation.Beta is the regression coefficient of the return on particular equity on the market return. The market return is typically represented by a broad index like the S&P 500. Beta measures the volatility of stock against the overall market, and the average beta of each individual investment in a portfolio represents the portfolio’s overall risk.
A beta of 0 indicates that the stock or total portfolio is uncorrelated with the overall stock market. A beta above 1 indicates a high correlation and low volatility, while a beta above 2 indicates a high correlation and high volatility. Equally, a negative beta indicates there is an inverse correlation between the portfolio and the market but high volatility.

Most assets have a beta between 0 and 2 over the long term.