Systematic risk, also known as market risk, refers to the risk inherent to the entire market or a specific market segment. This type of risk is caused by external factors that affect all investments in the market or segment, such as changes in the economy, political events, natural disasters, and global pandemics.
Systematic risk cannot be diversified away, as it affects all investments in the market. It is different from unsystematic risk, which can be diversified away by investing in a portfolio of assets that have low or negative correlations with each other.
Examples of systematic risk include a recession, a financial crisis, or a sharp rise in interest rates. These events can lead to a decline in stock prices and a loss of value for investments in the affected market or segment.
Investors can manage systematic risk by diversifying their portfolios across different asset classes and sectors. This can include investing in stocks, bonds, real estate, and alternative investments such as commodities or precious metals. By diversifying, investors can reduce the impact of systematic risk on their overall portfolio.
Another way to manage systematic risk is to use hedging strategies, such as buying put options or short-selling. These strategies allow investors to protect their portfolios against market downturns and limit their losses in the event of a market crash.
- Diversification: One of the most effective ways to manage systematic risk is through diversification. By investing in a range of different assets across different sectors, industries, and geographies, investors can spread their risk and reduce their exposure to any single market or segment.
- Asset allocation: Another way to manage systematic risk is through strategic asset allocation. This involves investing in a mix of asset classes, such as equities, bonds, and alternative investments, that are balanced according to an investor’s risk tolerance, investment goals, and time horizon.
- Hedging: Hedging is another strategy that can be used to manage systematic risk. For example, investors can use options contracts to protect against market downturns or short-sell securities that are expected to decline in value.
- Regular review and rebalancing: It is important for investors to regularly review their portfolios and rebalance their holdings to ensure that they remain aligned with their investment objectives and risk tolerance. This can help to manage systematic risk by reducing exposure to any single asset or market segment that may have become overvalued or over-weighted.
- Active management: Finally, investors can use active management strategies, such as tactical asset allocation or market timing, to adjust their portfolio holdings in response to changes in market conditions. However, it is important to note that these strategies can be risky and may not always lead to better returns.
In summary, systematic risk is the risk inherent to the entire market or a specific market segment. It cannot be diversified away and is caused by external factors that affect all investments in the market. Investors can manage systematic risk by diversifying their portfolios and using hedging strategies to protect against market downturns.