Financial Word of the Day: Systematic Risk
Every investment carries some level of risk. But some risks are specific to a company or industry, while others affect almost everyone at the same time.
That second kind of risk is what we call systematic risk.
Understanding systematic risk can help you become a smarter investor because it reminds you of an important truth: you can diversify away many risks, but you can’t diversify away everything.
What Is Systematic Risk?
Systematic risk is the risk that broad economic or market forces will negatively affect most or all investments.
It’s sometimes called market risk or non-diversifiable risk because it impacts the overall financial system rather than one particular company.
Common sources of systematic risk include:
Recessions
Inflation
Rising interest rates
Financial crises
Wars and geopolitical instability
Major changes in government policy
Global economic shocks
If one company loses an important customer, that’s probably not systematic risk. But if the economy falls into a deep recession and thousands of companies see their sales decline, that’s systematic risk.
A Simple Example of Systematic Risk
Imagine you own shares in 50 different companies.
You’ve done a great job diversifying. You own technology companies, banks, retailers, healthcare companies, manufacturers, and energy companies.
Then the economy enters a severe recession.
Consumers cut spending. Businesses delay expansion. Unemployment rises. Corporate profits decline.
Even though you’re well diversified, many of your investments may still fall in value. Why?
Because diversification protects you from company-specific risk, but it cannot completely protect you from systematic risk.
The storm is hitting the entire neighborhood, not just one house.
Systematic Risk vs. Unsystematic Risk
This distinction is important.
Systematic risk affects the overall market. Unsystematic risk affects a specific company, investment, or industry.
For example, suppose you own stock in only one restaurant company. If that company experiences a food-safety scandal, your investment could suffer dramatically. You could reduce that risk by owning many different companies.
But if a major recession causes the entire stock market to decline, simply owning more stocks probably won’t eliminate the problem.
That’s systematic risk.
Why Systematic Risk Matters to You
Understanding systematic risk keeps you from believing that diversification makes investing risk-free. It doesn’t.
Diversification is still one of the most powerful tools available to investors. But true diversification may involve thinking beyond simply owning several different stocks.
Depending on your goals and circumstances, you might spread your money across different asset classes, such as stocks, bonds, real estate, cash, commodities, or other investments.
Different assets may react differently to the same economic conditions.
You can’t eliminate systematic risk, but you can build a financial position that is better prepared to withstand it.
How to Use “Systematic Risk” in Conversation
You might say: “I’m well diversified across individual companies, but I know systematic risk could still cause my entire portfolio to decline during a major economic downturn.”
Congratulations. You just sounded like the smartest person at the coffee shop.
The Bottom Line
Systematic risk is the risk created by broad economic and market forces that affect many investments at the same time.
The goal isn’t to eliminate all risk. That’s impossible.
Instead, financially savvy people learn to identify risk, understand which risks they can control, and prepare for the risks they can’t. Learning the language of money helps you do exactly that.
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