Investing means taking a certain amount of risk in order to achieve your financial goals. There are distinct categories and types of risk investors contend with, including systematic and unsystematic risk. Systematic risk is driven by external factors, while unsystematic risk is internal. Understanding the difference between systematic risk and unsystematic risk is important when shaping an investment strategy, which we highlight below. You can utilize the help of a professional financial advisor in order to better understand what level of risk is right to help you meet your investment goals.
What Is Systematic Risk?
Systematic risk is the risk that’s produced as a result of external factors and affects the market as a whole. Factors that can drive systematic risk include changes to the geopolitical landscape, economic changes such as fluctuations in interest rates and natural disasters. In other words, systematic risk is the risk that cannot be directly controlled by individual investors, companies or other parties that operate inside the market system.
For example, there’s not much that you personally can do to prevent the economy from slipping into a recession. That’s because the factors that drive recessions and changes to the market cycle are beyond the scope of any one person or group. That’s how systematic risk works.
Individuals can, however, determine how they react to systematic risk when making investment decisions. For example, if signs are pointing to a recession, then you could diversify your portfolio to include investments that are likely to hold steady during a downturn. Or if you anticipate interest rate hikes, you might adjust your bond holdings to reflect that.
What Is Unsystematic Risk?
Unsystematic risk is a risk that’s inherent to a particular organization, industry or market segment. It’s essentially the opposite of systematic risk since unsystematic risk can be controlled and it may affect just one sector, versus impacting the market as a whole.
For example, say that new regulatory changes are set to take effect in the financial services industry. Companies within the industry could assess the potential negative impacts of those changes, then take steps to implement new standards, rules or practices to mitigate those impacts.
Or say a carmaker determines that a manufacturing flaw necessitates a recall of one of its vehicles. The company could assess the financial damage that may result from the recall and look for opportunities to recoup some of those losses. In that situation, the company has a measure of control over outcomes making this a form of unsystematic risk.
Systematic Risk vs. Unsystematic Risk: Key Differences
You might hold the view that when it comes to investing and the markets that all risk is the same. However, that’s not exactly true when discussing systematic and unsystematic risks as they function in different ways. Each type of risk differs systemically and can cause different reactions in your investment strategy.
Here are some of the most notable differences between each type of risk:
- Control: Systematic risk is generally uncontrollable, as it’s produced by various large-scale external factors. Unsystematic risk can be controlled, minimized or even avoided by the organizations that it affects.
- Scope: Systematic risk affects the market as a whole, which can have a broader carryover effect on an entire economy. Unsystematic risk is narrower in size, in the sense that it may only affect a single organization, industry or sector.
- Causes: When discussing systematic risk vs. unsystematic risks, there’s a distinct difference in what drives risk. Systematic risk operates on a macro level and is driven by things like political, economic and social factors. Unsystematic risk is driven by factors arising from within an organization.
- Nature of risk: Specific types of risk that fall under the systematic risk umbrella include things like interest rate risk and inflation risk. With unsystematic risk, the types of risk may be specific to an individual organization or industry. For example, if a company’s employees decide to go on strike to demand better wages or benefits the consequences of that action may be centralized around the company, rather than spreading across the market.
Both systematic and unsystematic risks can be disruptive but on a different scale. For example, if the housing market crashes that can hurt the broader economy. But if a real estate investment trust (REIT) you’ve invested in tanks, losses may be limited to yourself and the other investors who bought in.
How to Invest for Systematic Risk vs. Unsystematic Risk
Managing risk with your investments starts with understanding the nature of the risks you face, i.e., systematic or unsystematic. When dealing with systematic risk, calculating the right asset allocation can be your best bet for hedging against it.
Asset allocation simply means deciding how much of your portfolio to commit to various assets. So, you might have 70% of your portfolio in stocks, for example, with the remaining 30% held in bonds, cash or real estate.
Mixing up your asset allocation can provide some insulation against systematic risk to a degree. When all of your investments are tied up in a small handful of assets or just one asset, systematic risk can pose a far greater threat to your portfolio’s value. Choosing the right asset allocation can depend on your age, risk tolerance and overall goals.
Diversification can help with managing unsystematic risk. A diversified portfolio includes a mix of assets that are designed to help balance out the risk. So instead of concentrating all of your stock allocations on one or two companies or sectors, you might invest in mutual funds or exchange-traded funds (ETFs) that offer broader exposure to various segments of the market.
It’s also helpful to keep an eye on market news and trends, as well as the broader economic, political and social environment. Inflation, for example, is a systematic risk factor that can shrink your purchasing power as an investor. When inflation is higher, it might make sense to hedge against that with dividend stocks that steadily increase payouts or Treasury Inflation-Protected Securities (TIPS).
Can You Avoid Risk When Investing?
Risk is a natural part of investing, and every investment carries some degree of risk. The only way to avoid risk is to stay out of the market altogether.
That, however, can be a guaranteed way to fall short of your financial goals. While you could put money into a savings account or certificate of deposit (CD) account, the rate of return you can expect will likely fall far short of what you could get by investing your money in the market.
When your risk tolerance and risk capacity don’t match up, it can become much more challenging to build wealth. Risk capacity is a measurement of the amount of risk that you need to take to meet your goals.
Talking to your financial advisor can help you create a game plan for investing against the backdrop of systematic and unsystematic risk. If you’re new to investing, a professional advisor can help you to determine where you are on the personal risk tolerance scale and what types of investments might be appropriate.
The Bottom Line
Understanding systematic risk and how it compares to unsystematic risk can help with making more informed decisions as an investor. It can also help to put into perspective the types of things that may affect your portfolio’s returns in the short and long term. Ultimately, regardless of how you decide to manage your investments, your appetite for risk will have a large impact. It’s important to understand this before and during your investment journey.
Financial Planning Tips
- As mentioned, you can consider talking to your financial advisor about systematic and unsystematic risk, and what each one might mean for you. If you don’t have a financial advisor yet, finding one doesn’t have to be a hassle. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Automated portfolios might be an attractive investment option if you prefer to manage risk while being more hands-off. These portfolios can be offered at online brokerages and robo-advisors. You tell the brokerage or robo-advisor about your goals, risk tolerance and time frame for investing and the brokerage or advisor puts together a portfolio for you and all you have to do is schedule regular deposits.
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