Systematic Risk

Systematic risk is the portion of an asset's risk that stems from forces affecting the whole market or economy, rather than from anything particular to one company or issuer. Recessions, changes in interest rates, bursts of inflation, wars, pandemics and financial panics push most asset prices in the same direction at once. Because these shocks hit almost everything together, holding more assets does not make the risk go away. It is also called market risk or undiversifiable risk.

Its counterpart is unsystematic risk, also called specific or idiosyncratic risk: a failed product launch, a lawsuit or a factory fire at one firm. That kind of risk can be largely removed by diversification. The split is central to modern portfolio theory and the Capital Asset Pricing Model (CAPM), which hold that investors are rewarded only for bearing systematic risk. It should not be confused with systemic risk, the danger of the financial system itself breaking down.

Picture a harbour full of boats. Each boat has its own troubles: a leaky hull here, a careless skipper there. If you own shares in many boats, one sinking hurts but does not ruin you. When the tide goes out, though, every boat in the harbour drops at the same time, whichever ones you picked.

Systematic risk is the tide. It comes from the economy as a whole, so owning more boats does not protect you from it. The only ways to reduce it are to own fewer boats, keep some money on dry land in safer assets, or buy protection that pays out when the tide falls.

• The business cycle. Downturns in the business cycle and outright recessions cut profits across most industries.
• Interest rates and monetary policy. Changes in monetary policy alter the discount rate applied to all future cash flows and the cost of borrowing for every firm.
• Inflation and commodity shocks. A supply shock such as a jump in oil prices raises costs economy-wide.
• Currency movements. Large moves in the exchange rate affect all exporters, importers and foreign investors in a country.
• Political and global events. Wars, pandemics, sanctions and financial crises cause broad sell-offs, often sending markets into a bear market.

An asset's beta measures how strongly its returns move with the market. A beta of 1 means the asset tends to move in line with the market; above 1, it amplifies market moves; below 1, it dampens them. In a simple one-factor model, an asset's total variance splits into two parts:

• $\sigma_i^{2}$ is the total variance of the asset's returns.
• $\beta_i^{2} \sigma_m^{2}$ is the systematic part, where $\sigma_m^{2}$ is the variance of market returns.
• $\sigma_{\varepsilon}^{2}$ is the unsystematic, company-specific part.

Worked example: a share has a beta of 1.2 and a total standard deviation of 30%, while the market's is 20%. Systematic variance is $1.2^{2} \times 20^{2} = 576$, total variance is $30^{2} = 900$, so systematic risk accounts for 64% of the share's variance and the remaining 36% could in principle be diversified away.

Adding shares to a portfolio quickly reduces specific risk. Early research by John Evans and Stephen Archer in 1968 suggested that around ten randomly chosen US stocks removed most of it; later studies, including Meir Statman's in 1987, argued that 30 or more were needed, and research in 2001 by John Campbell and co-authors found that rising company-level volatility had increased that number. However many shares are held, the portfolio's risk levels off at the market's own systematic risk. Diversifying across asset classes, regions and sectors through asset allocation can lower it further, but correlations between assets tend to rise in crises, so the protection is weakest when most needed.

Because it cannot be diversified away, systematic risk is the risk investors are paid to bear. In CAPM, an asset's risk premium is proportional to its beta, and performance measures such as the Treynor ratio judge risk-adjusted return against it. Multifactor models extend the idea to several systematic risks, such as size, value and momentum.

Investors who want less systematic risk can hold more cash or short-term government debt, or hedge with derivatives: selling a futures contract on a stock market index offsets market moves, and buying put options limits losses for the cost of a premium. Such hedges also give up much of the expected reward, because removing systematic risk removes the premium that comes with it.

• Investor.gov (US SEC): Beta
• The Nobel Prize: 1990 Prize in Economic Sciences press release (Markowitz, Miller, Sharpe)