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Understanding Systematic Risk

Understanding Systematic Risk

Risk is an unavoidable aspect of investing. However, not all risks are the same. While some can be controlled, others end up affecting the entire market and cannot be avoided. This is where systematic risk enters. Be it investing in bonds, stocks, or commodities, systematic risk affects your portfolio due to the inevitable economic and political changes. Unlike company-specific risks, it cannot be eliminated via diversification.

If we speak a little more in detail, systematic risk arises from a number of factors like interest rate fluctuations, inflation, geopolitical events, recession, and financial crises. It affects all and every investment, thereby making it extremely crucial for investors to understand the depth of it.  Let's take a closer look at the essentials of systematic risk and how to move forward with it. But first, let's begin with what is systematic risk. 

What is Systematic Risk?

Systematic risk can be referred to as the inherent risk that has a major impact on the entire financial economy and market. It does not target a specific company or industry. It is unpredictable and cannot be avoided through diversification.

The reason for this is quite simple. Systematic risks arise from a wide range of external factors like inflation, economic downturns, geopolitical tensions, natural disasters, etc. Hence, investors cannot escape this entirely. For example, during a global recession or financial breakdown, the whole of the stock market may decline, irrespective of how well individual companies may perform. Furthermore, systematic risks impact all asset classes, i.e., bonds, stocks, real estate, commodities, etc. This is another reason why investors cannot potentially avoid it.

However, you can reduce its impact. Usually, this type of risk is measured using beta. It indicates how sensitive an asset is when it comes to overall market movements. A higher beta indicates that an asset is more volatile in response to market shifts. Investors and fund managers should account for systematic risk while building portfolios because it influences the returns as well (across all investments).

Types of Systematic Risk

Now that you know what is systematic risk, let's talk about the types. Systematic risk can be categorised into several types (depending on what affects the entire market). Some of these include:

  1. Market Risk
    Market risk is all about the fluctuations in the prices of assets due to investor sentiment, economic conditions, and global events. Several factors, like interest rate hikes, stock market crashes, or geopolitical events, can cause major and widespread volatility. For example, the 2008 financial crisis caused a major global market downturn, which affected all industries and asset classes. (more on this below)
  2. Inflation Risk
    Inflation wipes off the purchasing power, thereby reducing the real value of investments over time. If inflation rises beyond expectations, it can hurt fixed-income savings, securities, and long-term investments. This makes it harder for investors to maintain their wealth.
  3. Interest Rate Risk
    This risk arises due to the fluctuations in the interest rates. This can directly impact fixed-income investments like bonds. When interest rates rise, bond prices fall, and vice versa. It also affects borrowing costs for businesses and consumers, thereby influencing the overall economic growth.
  4. Currency Risk (Exchange Rate Risk)
    For investors who deal in foreign assets, currency fluctuations can significantly impact the overall returns. In case the local currency weakens against the foreign currencies, imports become expensive and inflation may rise. This risk is particularly relevant for companies that are engaged in international trade along with global investors.
  5. Political and Regulatory Risk
    Government policies, regulatory changes, and political instability can end up affecting the entire market. Policy shifts like trade restrictions, new financial regulations, or tax changes can also influence investment returns. For example, stricter environmental laws can impact industries like energy and manufacturing.

Causes of Systematic Risk

Systematic risk arises from factors that affect the entire financial market, not just individual companies. For example, economic downturns and recessions lead to lower consumer spending and reduced corporate earnings. This impacts every asset virtually. Changes in the monetary policy, like interest rate hikes or cuts by central banks change the borrowing costs and investment decisions on quite a wide scale.

Additionally, political uncertainty and regulatory changes also contribute significantly. Abrupt and sudden shifts in trade disputes, government policies, or geopolitical tensions can shake investor confidence and create a market-wide volatility. Global events like pandemics, conflicts, natural disasters, disrupted supply chains and economic activity further influences market behavior.

Consequently, another major factor is the interconnectedness of modern economies. If seen closely, a slowdown in one major economy can trigger a chain reaction. This can affect the market worldwide due to the increased reliance on investment and global trade. Currency fluctuations also play a major role. When a currency loses its value, it can influence the export and import, eventually affecting the pricing of commodities.

In a nutshell, since systematic risk comes from external forces that cannot be controlled, planning on solid risk management strategies are extremely important for investors.

Measuring Systematic Risk

Systematic risk is commonly measured using beta, a metric that indicates how much an asset or portfolio moves in relation to the overall market.

  • A beta of 1 suggests that the asset is moving in sync with the market.
  • A beta greater than 1 indicates higher risk as well as volatility.
  • On the other hand, a beta less than 1 indicates that the asset is less volatile than the market.

Another key measure involves R-squared value. This helps in determining how much of an asset's movements can be explained by market fluctuations. Investors and analysts also rely on CAPM (Capital Asset Pricing Model) to evaluate the expected returns based on an asset's systematic risk.

Strategies to Mitigate Systematic Risk

Some of the strategies to mitigate systematic risk invokes:

  1. Sector Diversification: Start allocating funds across multiple industries. By doing this, you can avoid heavy losses from sector-specific (healthcare, tech, or energy) declines.
  2. Asset Allocation: Spread out the investments across different asset classes. This involves bonds, equities, and commodities. It will reduce exposure to a single market downturn.
  3. Hedging with Derivatives: Use futures and options and swaps to offset the potential of losses during market downturns.
  4. Maintain Liquidity: Keep a solid portion of the portfolio in liquid or cash assets to move through market volatility and grab new opportunities. 
  5. Try Long-Term Investing Approach: Stay invested via market cycles instead of reacting to short-term fluctuations. This will reduce the overall impact of temporary downturns.
  6. Consider Geographical Diversification: Start investing in global markets. This will minimise the impact of region-specific economic downturns or any policy changes.
  7. Invest in Defensive Stocks: Choose stocks from sectors like utilities, healthcare, and consumer staples. These generally tend to be stable during potential economic downturns.
  8. Rebalance Your Portfolio Regularly: Adjust your asset allocation periodically. This will help you align with the changing market conditions and risk tolerance.
  9. Use Safe Assets: Begin with allocating funds to gold, government bonds, or inflation-protected securities during times of economic uncertainty.

Systematic Risk vs. Unsystematic Risk: Key Differences

Systematic risk is unavoidable as it impacts the entire financial system. However, unsystematic risk is controllable via proper diversification. Usually, a well-balanced investment strategy considers both types of risks to minimise the losses and balance the returns. Here's a tabular distinction:

Factor

Systematic Risk

Unsystematic Risk

Causes

Macroeconomic factors like interest rates, inflation, geopolitical events

Internal factors like product failures, labor strikes, and management issues

Also Known as

Non-diversifiable risk or market risk

Diversifiable risk or specific risk

Diversification Impact

Cannot be mitigated through diversification

Can be minimised by holding a diversified portfolio

Examples

COVID-19 pandemic, 2008 financial crisis, recession, interest rate hikes

Product recall, company bankruptcy, and industry-specific regulations

Mitigation Measures

Asset allocation, hedging, and investing in defensive sectors

Diversification across industries and companies

Real-world Examples of Systematic Risk

Some of the real world examples of systematic risk include:

  1. 2008 Global Financial Crisis
    Also known as the Great Recession, the collapse of Lehman Brothers triggered a worldwide financial breakdown. It led to economic downturns, market crashes, and high unemployment rates. This was a systematic failure that affected all investors and industries globally.
  2. COVID-19 Pandemic (2020)
    COVID is yet another example of an external risk that affected the whole world’s financial ecosystem. This unanticipated outbreak that led to lockdowns across the globe affected businesses, big and small.
  3. Demonetisation in India (2016)
    When the Indian government invalidated ₹500 and ₹1,000 currency notes in the year 2016, cash shortage, disruption in business and slow financial growth were instantly visible effects. This was one decision that had a rippling effect all across the industries and thus impacted millions.
  4. Global Recession (2000, 2008, 2020)
    The turn of the century brought several economic downturns. Loss of jobs, market crashes and businesses shutting down were some hard-hitting examples of systematic risk that affected even the strongest of economies.
  5. Interest Rate Hikes by Central Banks
    When central banks like the RBI (Reserve Bank of India) or the Federal Reserve raise or increase interest rates, the borrowing cost also rises. This starts affecting businesses, investors, and consumers. Eventually, stock markets decline, and economic growth slows.
  6. Geopolitical Conflicts
    Systematic risks can also arise in the events of political instability. In the past few months, the world has witnessed wars that have further disrupted markets and supply chains. Such unpredictable events greatly impact the movements in the market and become an important example of systematic risk.

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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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Bajaj Financial Securities Limited and its associates, officer, directors, and employees, research analyst (including relatives) worldwide may: (a) from time to time, have long or short positions in, and buy or sell the securities thereof, of company(ies), mentioned herein or (b) be engaged in any other transaction involving such securities and earn brokerage or other compensation or act as a market maker in the financial instruments of the subject company/company(ies) discussed herein or act as advisor or lender/borrower to such company(ies) or have other potential/material conflict of interest with respect to any recommendation and related information and opinions at the time of publication of research report or at the time of public appearance. Bajaj Financial Securities Limited may have proprietary long/short position in the above-mentioned scrip(s) and therefore should be considered as interested. The views provided herein are general in nature and do not consider risk appetite or investment objective of any particular investor; readers are requested to take independent professional advice before investing. This should not be construed as invitation or solicitation to do business with Bajaj Financial Securities Limited.  

Bajaj Financial Securities Limited or its associates may have received compensation from the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates may have managed or co-managed public offering of securities for the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates may have received compensation for investment banking or merchant banking or brokerage services from the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates may have received any compensation for products or services other than investment banking or merchant banking or brokerage services from the subject company in the past 12 months. Bajaj Financial Securities Limited or its associates have not received any compensation or other benefits from the Subject Company or third party in connection with the research report. Research analyst or his/her relative or Bajaj Financial Securities Limited’s associates may have financial interest in the subject company. Bajaj Financial Securities Limited, its associates, research analyst and his/her relative may have other potential/material conflict of interest with respect to any recommendation and related information and opinions at the time of publication of research report or at the time of public appearance.  

Research analyst has served as an officer, director or employee of subject Company: No  

Bajaj Financial Securities Limited has financial interest in the subject companies: No  

Bajaj Financial Securities Limited’s Associates may have actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report.  

Research analyst or his/her relative has actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report: No  

Bajaj Financial Securities Limited has actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report: No  

Subject company may have been client during twelve months preceding the date of distribution of the research report.  

There were no instances of non-compliance by Bajaj Financial Securities Limited on any matter related to the capital markets, resulting in significant and material disciplinary action during the last three years. A graph of daily closing prices of the securities is also available at https://www.nseindia.com/

ANALYST CERTIFICATION

The analyst for this report certifies that all of the views expressed in this report accurately reflect his or her personal views about the subject company or companies and its or their securities, and no part of his or her compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this report.  

RISK DISCLOSURE ON DERIVATIVES

  • 9 out of 10 individual traders in equity Futures and Options Segment, incurred net losses.
  • On an average, loss makers registered net trading loss close to ₹ 50,000.
  • Over and above the net trading losses incurred, loss makers expended an additional 28% of net trading losses as transaction costs.
  • Those making net trading profits, incurred between 15% to 50% of such profits as transaction cost.

SEBI study dated January 25, 2023 on “Analysis of Profit and Loss of Individual Traders dealing in equity Futures and Options (F&O) Segment”, wherein Aggregate Level findings are based on annual Profit/Loss incurred by individual traders in equity F&O during FY 2021-22.

BROKERAGE DISCLAIMER

All leveraged intraday positions will be squared off on the same day. There is no restriction on the withdrawal of the unutilised margin amount. Brokerage will not exceed the SEBI prescribed limit. Visit : https://www.bajajbroking.in/pricing

MTF 

As subject to the provisions of SEBI Circular CIR/MRD/DP/54/2017 dated June 13, 2017, and the terms and conditions mentioned in the lights and obligations statement issued by the TM (if applicable).  

US INVESTING

International investment is not supervised by any regulatory body in India. Thus, any claim or dispute relating to such investment or enforcement of any agreement/contract /claim will not be under laws and regulations of the recognized stock exchanges and investor protection under Indian Securities Law. The account opening process will be carried out on Vested platform and Bajaj Financial Securities Limited will not have any role in it.  

MARKETSMITH / GOLDENPI / SOVEREIGN GOLD BONDS

Bajaj Financial Securities Limited is only distributor of this product. These are not exchange traded products and all disputes with respect to the distribution activity, would not have access to exchange investor redressal forum or Arbitration mechanism. Bajaj Financial Securities Limited is not a registered Investment Advisory. User discretion is required before investing. Client is requested to independently evaluate and/or consult their professional advisors before arriving at any conclusion to make any investment. The decision to invest shall be the sole responsibility of the Client and shall not hold Bajaj Financial Securities Limited, its employees and associates responsible for any losses, damages of any type whatsoever. 

IPO 

This should not be construed as soliciting investment. Investors’ discretion is required. Kindly consult your financial expert before investing. No need to issue cheques by investors while subscribing to IPO. Investments in securities markets are subject to market risks, read all the related documents carefully before investing.  

SCREENERS 

Screeners is not Exchange-approved products and any disputes related to the same will not be dealt on the Exchange platform. 

SECURITIES 

Securities quoted are exemplary and not recommendatory. 

IPV 

Account would be open after all procedure relating to IPV and client due diligence is completed. 

IMAGES 

The images used are only for representation purpose. Proper due diligence has been done for the images and the image is not of any artist. The same is captured from royalty free sites. 

DISCLOSURE TO CLIENTS REGARDING PAYOUT OF FUNDS

As per SEBI circular no. SEBI/HO/MIRSD/MIRSD-PoD-1/P/CIR/2023/84 dated June 08, 2023, Stockbrokers are required to upstream the entire client funds lying with them to the Clearing Corporation. Based on client’s request the funds’ release request must be placed with the Clearing Corporation. Based on the internal process and cut-off timelines of the Clearing Corporation the funds will be released to the Stock Broker. In view of this new process, as specified by the regulatory and the cut-off time of Clearing Corporation/Banks processing the funds, Bajaj Financial Securities Limited cannot commit the exact time for releasing funds payout to its client. Clients are requested to note that, Bajaj Financial Securities Limited will not be responsible for any inconvenience caused to clients due to delay in release of funds payout, including fines, delayed charges, defaults, etc.