When it comes to investing and finance, there are many types of risks to consider. Two common types of risk are systemic risk and systematic risk. While these terms sound similar, they have different meanings and implications for investors. In this article, we will define systemic risk and systematic risk, explore their differences, and provide examples of how they can impact investments.
Systemic Risk
Systemic risk refers to the risk of a widespread failure within a financial system or market, leading to a breakdown in the entire system. Systemic risk is often referred to as the risk of a “financial contagion” that spreads through the financial system, causing widespread damage.
Systemic risk can arise from various sources, including economic downturns, political instability, or financial market disruptions. When systemic risk materializes, it can impact the broader economy, leading to recession or even a depression.
An example of systemic risk is the 2008 global financial crisis. The financial crisis was caused by the collapse of the US housing market, which led to widespread failures in the banking system. The failure of large financial institutions, such as Lehman Brothers, triggered a financial contagion that spread throughout the global financial system, leading to a severe economic downturn.
Systematic Risk
Systematic risk, on the other hand, refers to the risk that is inherent in the entire market or system, rather than the risk specific to a particular security or company. Systematic risk is also known as market risk, and it cannot be diversified away by investing in a single security or asset class.
Systematic risk arises from various sources, including interest rate changes, inflation, economic growth, and geopolitical events. These factors can impact the entire market, leading to a rise or fall in stock prices and returns.
An example of systematic risk is the impact of a recession on the stock market. During a recession, the overall economic activity slows down, leading to a decrease in consumer spending and business investment. As a result, the stock market tends to decline, reflecting the overall decline in economic activity.
Differences between Systemic Risk and Systematic Risk
The primary difference between systemic risk and systematic risk is their scope. Systemic risk is a broader risk that can impact the entire financial system, while systematic risk is a risk inherent in the entire market or system.
Another difference between the two is their diversification potential. Systematic risk cannot be diversified away by investing in a single security or asset class, while systemic risk can be mitigated by diversification across different types of investments and asset classes.
Finally, the impact of systemic and systematic risk is different. Systemic risk has the potential to cause widespread damage to the financial system and broader economy, while systematic risk impacts investment returns and the overall market.
How to Mitigate Systematic Risk and Systemic Risk
While it is impossible to eliminate systemic and systematic risk entirely, there are several ways investors can mitigate their impact:
- Diversification: Diversification is essential to mitigating both systemic and systematic risk. Investing across different asset classes and securities can reduce the impact of a specific event on your portfolio.
- Hedging: Hedging is a strategy that involves taking an opposite position in the market to reduce the impact of adverse price movements. For example, buying put options can provide protection against market downturns.
- Risk Management: Implementing a risk management strategy can help mitigate the impact of both systemic and systematic risk. This strategy can include regularly monitoring the market and adjusting your portfolio accordingly.
- Investing in Low-Correlation Assets: Investing in assets that have a low correlation with the overall market can help reduce the impact of systematic risk. Examples of low-correlation assets include commodities, real estate, and alternative investments.
Conclusion
In conclusion, systemic risk and systematic risk are two different types of risk that investors should understand and consider when making investment decisions. Systemic risk is a broader risk that can cause widespread damage to the financial system and economy, while systematic risk is inherent in the overall market or system. Diversification, hedging, risk management, and investing in low-correlation assets are all ways investors can mitigate the impact of both types of risk. By understanding these risks and implementing appropriate risk management strategies, investors can better protect their portfolios and potentially achieve their investment goals.
