Meaning and definition of systematic risk
Systematic risk refers to the risk intrinsic to the complete market or the complete market segment. Systematic risk is also sometimes referred as “market risk” or “un-diversifiable risk”. As explained by Investopedia, recession, wars, and interest rate represent the sources for systematic risk for they affect the complete market and are unavoidable through diversification. While this risk type affects a wide range of securities, unsystematic risk affects quite a particular group of securities or even an individual security. Moreover, systematic risk can be reduced by just being hedged.
Example of systematic risk
To illustrate systematic risk, let us take the example of an individual investor who purchases stock worth $10,000 I 10 biotechnology companies. If unexpected events lead to a appalling setback and one or more companies face a drop in the stock price, the investor experiences a loss. On the contrary, an investor purchasing stock worth $100,000 in a single biotechnology company would experience ten times the loss from such an event.
The second investor’s portfolio involves more unsystematic risk as compared to the diversified portfolio. As a final point, if the setback was aimed at affecting the complete industry instead, the investors would experience similar losses, resulting from systematic risk.
Sources of systematic risk
Systematic risk results from political factors, economic crashes, and recessions, changes in taxation, natural disasters, and foreign-investment policy. These risks are widespread as they can affect any investment or any organization.
Systematic risks are a little difficult to be mitigated. This is due to the reason that they are brought forth by the existing economic conditions or similar factors which are not in the control of the business management.
Systematic risks are recognized by estimating and analyzing the statistical relationships between the different asset portfolios of an organization through the use of techniques like principal components analysis.
There is, however, no well defined method for handling systematic risks as they show impact on the entire market.
The decision of the investor on whether to reject or accept different investment options depends upon the risk type carried by the investment. In case of systematic risk like inflation, investors would like to invest in stable and less risky portfolio like a real estate.