Last editedJuly 20212 min read
The words may be similar, but systemic and systematic risks carry quite different meanings in finance. We’ll take a closer look at their definitions and differences below, so that you can create a more effective risk management strategy and protect your portfolio.
Systemic risk definition
In medical terminology, a systemic risk describes a specific health issue that goes on to impact the full body. In finance, it takes on a similar meaning. A systemic risk describes the likelihood that a single event could spark collapse in an industry or the wider economy. The event occurs at the corporate level and often goes on to trigger a broad market downturn.
Systemic risks include things like individual business, financial institution, or full industry failure. Smaller events can also qualify as systemic risks, such as security flaws discovered on a bank account. Even the smallest systemic risks can have a serious impact on the sector or industry, with the fall of major banking institutions potentially leading to economic crisis and market collapse.
Systematic risk definition
While systemic risks refer to individual events with the potential for broad impact, the systematic risk definition is quite different. A systematic risk is one that’s already lurking in the economy. Also called ‘market risk’, systematic risk impacts the full market rather than a single sector or industry.
Political situations, economic conditions, currency fluctuations and interest rates are all big-picture systematic risks. Investors can’t avoid these types of risks. Risk management systems must simply account for the possibility of market volatility and political instability. While you can diversify your portfolio to protect against systemic risks, systematic risks are more difficult to account for.
Differences between systemic vs. systematic risk
Here are the key differences to be aware of when looking at systemic and systematic risk:
As we’ve outlined above, systemic risks refer to a situation sparked by a single event that in turn potentially leads to wider collapse or downturn. Systematic risk impacts the full market and is caused by things ranging from global recession to natural disasters or war.
You can’t fully predict systemic risks, since it’s often unclear how the fall of a financial institution or business will create wider fallout in the economy. However, systematic risks, once identified, can be somewhat predictable in their path. For example, we know how recessions or a rise in interest rates tend to impact the market and can prepare accordingly.
3. Measurement systems
To measure systemic risk, investors may use techniques such as marginal expected shortfall (MES) which looks at how a company’s single risk impacts broader industry risk. Investors often use beta to measure systematic risk in relation to a portfolio. If your portfolio’s greater than or equal to 1, this indicates it carries more systematic risk because it will be impacted by market volatility.
4. Risk management
You can protect against systemic risks by diversifying your portfolio. This ensures that you don’t put all your money into a single company, sector, or industry. If that business or industry fails, you’d lose your investment. However, systematic risk can’t be helped with diversification due to its broad nature. Yet you can mitigate systematic risks with a variety of different asset classes, including a blend of real estate, cash, and equities. For example, commodities like gold are a popular option for investors hoping to avoid systematic risk.
Systemic vs. systematic risk examples
A prime example of systemic risk would be the collapse of Lehman Brothers in 2008. When this international financial services company went bankrupt, it caused a domino effect that led to a wider banking collapse.
For systematic risk examples, we can look at the Covid-19 pandemic. Pandemic risk is something that’s always a possibility but difficult to predict. When it occurred, this led to widespread business closures, lockdown, and disruptions to global travel. The 2008 financial crisis and Great Recession is another example, impacting multiple asset classes in different ways.
It’s helpful to keep these differences between systemic vs. systematic risk in mind in order to develop a carefully crafted risk management system. Diversification, both in terms of individual stocks and asset classes, is the best way to mitigate risk of all types.
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