Definition: Systematic risk, also known as market risk or volatility risk, signifies the inherent danger in the unexpected nature of the market. This form of risk has an impact on the entire market and not on individual securities or sectors.
What Does Systematic Risk Mean?
What is the definition of systematic risk? Systemic risk contains the impact of a recession, inflation and interest rate changes on the entire market, and therefore, it is extremely volatile, and it cannot be leveraged through diversification.
For instance, constructing a diversified portfolio with optimum asset allocation in bonds and stocks can leverage systemic risk to the extent that a rise in the interest rate lowers the value of bonds and increases the value of stocks, thus limiting the impact of the systemic risk on portfolio returns.
Let’s look at an example.
Example
Theresa holds a diversified portfolio constructed of 500 shares of a technology company, 500 corporate bonds, and 500 municipal bonds. Theresa worries about the recent cut in the interest rates, and she wants to know the systematic risk of the stocks that she holds in the portfolio.
Given that the portfolio beta is 1.8, Theresa understands that her portfolio returns fluctuate 1.8 times more than the market returns. If the market increases 3%, Theresa’s portfolio will increase 3% x 1.8 = 5.4%. If the market declines 3%, Theresa’s portfolio will decline 5.4%. How can Theresa hedge portfolio risk?
Theresa has to lower the exposure of the portfolio to stocks and increase the exposure of the portfolio to bonds because bonds do not fluctuate sharply. The new asset allocation in Theresa’s portfolio includes 200 shares of a technology company, 500 corporate bonds, and 800 municipal bonds. The new portfolio beta is 0.8, suggesting that Theresa’s portfolio is less volatile than the market, thus hedging systemic risk.
Generally, risk-averse investors prefer a portfolio with a beta of less than 1 so that they incur lower losses in case the market declines sharply. Conversely, risk-taker investors prefer securities with high betas, seeking for higher returns.
Summary Definition
Define Systematic Risk: Systemic risk is chance that the market will go up or go down and your investment will be affected.
