Systemic risk is generally used in reference to an event that can trigger a collapse in a certain industry or economy, whereas systematic risk refers to overall market risk. Systemic risk does not have an exact definition, many have used systemic risk to describe narrow problems, such as problems in the payments system, while others have used it to describe an economic crisis that was triggered by failures in the financial system. Generally, systemic risk can be described as a risk caused by an event at the firm level that is severe enough to cause instability in the financial system.
On the other hand, systematic risk does have a more recognized and universal definition. Sometimes plainly called market risk, systematic risk is the risk inherent in the aggregate market that cannot be solved by diversification. Some common sources of market risk are recessions, wars, interest rates and others that cannot be avoided through a diversified portfolio.
Risk is something every investor is concerned about, along with return, when choosing an investment. Risk, however, isn’t always a simple thing to define. Understanding the difference between systematic risk and unsystematic risk will help an investor make the smartest decisions, whether they are a “pro” at investing or a “first-timer”.
The first type, systematic risk, is the inherent risk in being involved in the stock market at all. This risk is affected by factors that affect the stock market as a whole, such as inflation, wars, political changes, etc. These factors affect the entire financial world and not just one particular company or industry.
Unsystematic risk, on the other hand, which can also be called specific risk, is the risk that applies only to one specific company. Poor performance, product returns or recalls, employee strikes or office calamities are all examples of unsystematic risk.
Diversification among the two will help prevent a portfolio from suffering too greatly by one affected company or industry or some other type of financial calamity.
Unsystematic risk is significant if an investor has a large portion of his portfolio invested in one specific company or industry. The need to balance the effects of unsystematic risk, so that a portfolio is not completely wiped out by a single event, is why advisors usually suggest investors diversify their portfolio.
Balancing systematic risk is difficult, because no company or industry can avoid the losses that come from major news in the financial or political world. There are ways to hedge the losses that might occur.
For instance, a hedge against an entire economy underperforming is to invest in companies or industries that manage to weather all financial difficulties better than most. Long-standing businesses or essential products and services are examples of investments that will lose less in hard economic times.
Unsystematic risk is avoidable through diversification, and selective diversification is a way to manage the level of systematic risk one’s portfolio might have. But, as they say in almost every prospective ever printed, there is an element of risk in any investment.
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