Systematic risk is the risk associated with the environment a business operates in. This risk occurs due to external factors and is outside the control of a particular business.
This risk applies to the market or market segment, the business operates in, as a whole and not to a particular company or industry.
Investors cannot diversify systematic risk for a particular class of investment as it relates to all investments of the same class in a market.
Investors with many different stocks and a diversified portfolio still have to deal with systematic risks for investments in a particular market.
For example, if different investors have a diversified portfolio of different stocks, they will be affected the same during a stock market crash.
Instead, investors can manage or minimize systematic risk by diversifying their portfolios with different classes of investments.
For example, an investor that has invested in only stocks of companies can minimize the systematic risk by investing in other classes of assets such as real estate.
In simple terms, investors can manage systematic risk by investing in a different market or market segment altogether.
Investors can also manage the systematic risks of their investments through hedging. For example, when the interest rates in the market increase, an investor that has invested in fixed interest rate instruments will be affected.
They can hedge the risk by using different tools such as Forward Rate Agreements, Futures, Swaps, Options, etc.
Systematic risk consists of many types of risks. It includes interest rate risk, which is the risk that investors have to bear due to interest rate changes in the market.
It also includes exchange rate risk, the risk which arises due to forex rate changes and affects the market as a whole.
Additionally, it also includes inflation risk, a risk that arises due to inflation changes.
Systematic risk can be better explained by understanding unsystematic risk first. The unsystematic risk or specific risk is the risk that is specific to a company or industry.
Unsystematic risk exists for every investment. However, unlike systematic risk, investors can manage unsystematic risk by diversifying their portfolios.
Unsystematic risk exists due to internal factors of the company or the industry unlike systematic risk, which exists due to external factors.
Therefore, this risk can be controlled by companies because it is internal. Because unsystematic risk is specific to an investment, it only affects the market value of the investment, while systematic risk affects the market value of the market as a whole.
The systematic risk of an investment can be measured by calculating the beta coefficient of the investment.
The beta coefficient of an investment is the measure of its volatility compared to the market.
It illustrates how the value of the investment will change with changes in the systematic risk of the market it is operating in.
The value of the beta coefficient can be from 0 to 2; if the value of the beta coefficient equals 1, the systematic risk of the investment is the same as the market as a whole.
If the beta coefficient of investment lies between 0 and 1, i.e. lower than 1, then the stock’s systematic risk is said to be lower than that of the market as a whole.
This means that the investment is less risky compared to the market’s overall risk. It also signifies that any changes in the risk of the market overall will have a lower impact on the risk of the company.
A beta coefficient between 1 and 2, i.e. greater than 1, indicates that the company’s systematic risk is higher than that of the market as a whole.
This means that the investment is riskier than the market’s overall risk. Moreover, it signifies that any changes in the risk of the market overall will have a higher impact on the company’s risk.
Furthermore, the beta coefficient quantifies the change in the value of an investment relative to the market it is operating in.
For example, if an investment has a beta coefficient of 1.3, it means that for every point change in the value of the market as a whole, the value of the investment will change 1.3 times or 30% more than the change in the value of the market.
In contrast, if the beta of an investment is 0.7, for every point change in the value of the market overall, the value of the investment will change 0.7 times or 30% less.
To calculate the beta coefficient of a particular investment, the following formula can be used:
Beta Coefficient = Covariance (Return on individual investment, Return on overall market) / Variance (Return on the overall market)
Covariance is the measurement of the changes in the returns on an investment relative to the overall return on the market.
This is calculated by taking the covariance of the relative changes in the values of the investment and the relative changes in the value of the market overall.
Variance measures how much the market’s data points differ from their average value or mean point.
This is calculated by establishing a mean value for the market and calculating any relative spread over the mean point.
Disadvantages of Using Beta Coefficient
While the beta coefficient can be used to measure the systematic risk of an investment, it has some disadvantages when used to calculate the systematic risk.
The calculation of the beta coefficient only considers historical data when measuring the systematic risk of an investment.
This means this tool does not provide an accurate systematic risk for investors looking to predict future information about an investment.
The beta coefficient is only useful when it comes to calculating the short-term systematic risk of an investment.
For long-term purposes, the beta coefficient cannot be relied on to estimate systematic risk accurately due to the volatility of the data used in calculating the beta coefficient.
The value of the investment and the market is unstable and can change significantly due to unforeseen circumstances.
The systematic risk of an investment is the risk due to the market it operates in and does not relate to a specific investment or industry.
This is different from unsystematic risk which is the risk associated with a particular investment or industry.
The systematic risk of an investment can be measured using the beta coefficient.