Methodology

Stocks

Module 2

What is systematic risk also known as?

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Systematic Risk

Systematic Risk

Systematic risk, also known as market risk, is a risk that typically affects the whole market. Therefore, systematic risks typically have an impact on every stock that is listed on a stock market. Such risks are known as undiversifiable as it is very difficult to diversify away from them. They are unpredictable and impossible to avoid.

 

Systematic risks could be political, social, environmental or economic in nature.  Examples include: rising inflation, war, protectionism, epidemics or earthquakes.  

 

As you can imagine, systematic risks are what inexperienced investors fear the most. With there being very little that can be done to overcome such risks, many investors fear making big losses and being unable to do much to stop it from happening. In reality, systematic risks are typically short term in nature and happen rarely. 

Managing systematic risk

As mentioned, systematic risks are typically short term in nature and do not happen very often. So, an easy way to manage systematic risks would be to take a long term approach to investing. If you invest with the intention of holding investments for the long term, then short term market fluctuations shouldn’t bother you so much. If you intend to invest over the short term, the chance of making loses as a result of systematic risk is much more likely.

 

In addition, investing in countries that are developed is a key consideration. Systematic risks occur in all countries, but the frequency of such events happening usually depends on how developed a country is. This is because more developed countries are more stable and have systems in place to overcome major events that can disrupt the financial system. For example, the United States is very unlikely to experience a war on American soil with the huge amount of military resources that they have on hand. This means that the likelihood of the American stock market being disrupting by war is incredibly small.

 

Finally, investing in a range of assets will reduce the impact that systematic risk has on your portfolio. If you invest in stocks only, consider widening the types of investment that you hold, perhaps with bonds or cash investments.

 

As always, investing internationally will reduce your exposure to systematic risk in many cases. With that said, with the world being so globalised these days, many countries will often be exposed to the same risks.

Measuring systematic risk

An investor can observe how a stock is likely to react to systematic risk by looking for a statistic called beta. Beta is a measure of how volatile a stock is, compared with the rest of the stock market.

 

The stock market, as a whole, has a beta that is equal to 1. So, if a stock has a beta that is greater than 1, then it means that it is more volatile than the rest of the market. Likewise, if a stock has a beta that is less than 1, then it means that it is less volatile than the rest of the market. For example, if a stock has a beta of 1.5, then it means that it is 50% more volatile than the rest of the market. So, if the market increases in value by 10%, then that stock should increase by around 15%.

 

Likewise, if a stock has a beta of 0.5, then it means that it is 50% less volatile than the rest of the market. So if the market increases by 10%, then that stock should increase by 5%.

 

Therefore, to reduce your exposure to systematic risk, investing in stocks with a beta that is less than 1 is advantageous. At the same time, it will reduce the risk in your portfolio in general, meaning that your return will likely decrease. 

 

Beta is easy to find and is usually given with other information when you look for the stock price of a company. 

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