Understanding Systematic Risk in Investments
“Do not keep all your eggs in one basket” is a widely known term in investment vocabulary. The idea behind is not to concentrate all your investments in one asset, rather diversify your investments. For example in very simple terms do not invest all your money in one company’s stocks. Because in case the company fails to perform due to various reasons (such as a new competitor enter into the market, regulatory changes, product failure …etc) you will lose your whole investment. But if you had invested in different stocks, diversified your investments, you will lose only the fraction that you have invested in that particular company. This is known as Unsystematic Risk or the Diversifiable Risk in Investment terminology.
However, it’s not this Diversifiable Risk that we are focusing in here. Suppose you have stored your eggs in different baskets and put in your store room separately. What if the egg market collapses? You will still end up losing money which is beyond your control. Then what we can do in such a scenario.
This particular risk in investments is known as Systematic Risk. Unlike Unsystematic Risk this cannot be eliminated by diversification. It is inherent to the whole financial system, market or a market segment, not to a single asset class such as stocks or a specific industry.
Systematic Risk, the failure of the system from investor’s eyes could be due to various factors. Recessions, Pandemics, Interest Rate changes, Currency Crises, Wars are to mention a few among them. Classic examples for such events are the great recession in 2008 and collapse of many economies which we are seeing today due to COVID-19 pandemic.
How to deal with Systematic risk from an investor’s point of view?
One way to deal with Systematic Risk is to follow a suitable asset allocation strategy. An investor can build his/her portfolio by including a variety of asset classes. But need to ensure that these asset classes reacts in different ways in case of a major change in the economy mentioned above. For example an investor can chose to include real estate and interest bearing assets (such as fixed deposits) to build his or her portfolio. In an event where interest rates come down, still the investor may observe the value of the real estate increases. (Usually when interest rates are low people tend to move from financial assets to real assets such as real estate).
On the other hand an Investor can use hedging techniques to mitigate the impact from Systematic Risk. There are various hedging instruments are used in today’s financial world and an investor can select the best suited solution. Interest Rates Swaps, Currency Swaps, Forwards, Futures, Options are some popular hedging products to be named. (Describing these products in detail will be a separate article). However if one to use hedging to safeguard investments from Systematic Risk, he or she needs to understand the hedging product and their features very well. Hedging products come at a cost and if one does not understand the features and terms and conditions of them it might cost more to the investor. The history provides more than enough examples where hedging techniques went wrong for investors.
However if an investor wants to analyze the systematic risk inherited with a specific asset, he/she can study the beta value of the particular asset. Beta value indicates the volatility of an asset in relation with the market. In other words it tells you the correlation of the price movement of the particular asset to the price movement of the entire market.
Through a statistical analysis under various scenarios one can derive the beta value of an asset.
However it is very important to understand and mitigate the systematic risk for an investor to reap the best from an investment he or she is going to make.
Senior Analysts – Team STATISTICIA