Systemic Risk vs Systematic Risk
Systemic risk and systematic risk are both forms of financial risk that need to be closely monitored and considered by potential and current investors. Both forms of risk can result in the investor losing a major portion of his investment, and since they are both so unpredictable in nature investors must consider the possibility that such risks may cause large losses to investment returns. Systemic risk and Systematic risk are very different to each other, and the distinction is quite clear and simple. The following article clearly explains each form of risk and their implications, while clearly outlining their differentiating factors.
What is Systematic Risk?
Systematic risk is the risk that may affect the functioning of the entire market and cannot be avoided through measures such as portfolio diversification. Portfolio diversification is the inclusion of a variety of securities and investments that have varying levels of risk, returns, maturities, and other different characteristics, into a portfolio.
Systematic risk is also called ‘market risk’ or ‘un-diversifiable risk’ and examples of such risks include recession, wars and political instability, rising interest and inflation, and natural disasters that affect the entire market. Systematic risk cannot be diversified; however, it can be hedged against by using other money market securities that can be used to offer returns to investors even when markets are not doing as well as predicted.
What is Systemic Risk?
Systemic risk is the risk that affects a certain industry that is usually caused by an event that triggers such a collapse. Since systematic risk only affects one particular industry, it can be diversified. This means that investors can escape the risk inherent to one industry by populating their investment portfolio with a bunch of different securities from a number of industries with hope that losses made from investments in one industry can be overcome by profits made in investments other industries.
Example of a systemic risk is the collapse of Lehman Brothers that triggered a collapse in the banking system of the United States with ripple effects across the economy, which resulted in many investors losing confidence.
Systemic Risk and Systematic Risk
Systematic risk and systemic risk both affect the financial well being of an industry or an entire market and must be watched out for by potential investors. Of the two forms of risk, systemic risk poses less damage since systemic risk can be avoided or reduced through investing in a well diversified portfolio. Systematic risk, on the other hand, is much more damaging since it affects the entire market and cannot be diversified away. Hedging is possible, but a correct assessment of the risk is required in order to hedge, which may not always be a skill possessed by most investors.
Summary
Systemic Risk vs Systematic Risk
- Systemic risk and systematic risk are both forms of financial risk that need to be closely monitored and considered by potential and current investors.
- Systematic risk is the risk that may affect the functioning of the entire market and cannot be avoided through measures such as portfolio diversification.
- Systemic risk is that risk that affects a certain industry that is usually caused by an event that triggers such a collapse.
- Of the two forms of risk, systemic risk poses less damage since systemic risk can be avoided or reduced through investing in a well diversified portfolio.
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