Systemic vs. Systematic Risk: Understanding the Difference

Systemic vs. Systematic Risk: An Overview

Systemic risk is generally used in reference to an event that can trigger a huge collapse in a certain industry or overall economy, whereas systematic risk refers to the overall, ongoing market risk that is derived from a variety of factors.

Systemic risk is often a complete, exogenous shock to the system, such as the threat that one of the major banks that collapsed during the 2008 financial crisis could then trigger a massive market implosion. Systematic risk is the overall, day-to-day, ongoing risk that can be caused by a combination of factors including the economy, interest rates, geopolitical issues, corporate health, and other factors. Systemic risk is harder to quantify and harder to predict, whereas a systematic risk is more quantifiable and can be anticipated, in some cases.

Systemic Risk

Generally, systemic risk can be described as a risk caused by an event at the company level that is severe enough to cause instability in the financial system.

Systematic Risk

On the other hand, systematic risk does have a more recognized and universal definition. Sometimes plainly called market risk, systematic risk is the risk inherent in the aggregate market that cannot be solved by diversification. Some common sources of market risk are recessions, wars, interest rates and others that cannot be avoided through a diversified portfolio. Though systematic risk cannot be fixed with a different asset allocation strategy, it can be hedged. The risk that is specific to a firm or industry and can be solved by diversification is called unsystematic or idiosyncratic risk. With Systematic risk, diversification won’t help, because the risks are much broader than one sector or company.

Investors hoping to mitigate the risks of systematic risk can make sure that their portfolios include a variety of asset classes, such as equities, fixed income, cash, and real estate, as each of these will react differently to a major systemic change.

Systemic vs. Systematic Risk Example

As an example of systemic risk, the collapse of Lehman Brothers in 2008 caused major reverberations throughout the financial system and the economy. The size of Lehman Brothers and deep integration in the economy caused its collapse to result in a domino effect that generated a major risk to the global financial system, necessitating government intervention.

The Great Recession” of the late 2000s is an example of systematic risk. Anyone who was invested in the market in 2008 saw the values of their investments change drastically from this economic event. This recession affected asset classes in different ways as riskier securities were sold off in large quantities, while simpler assets, such as U.S. Treasuries increased their value.

Key Takeaways

  • Systemic risk and systematic risk are both dangers to the financial markets and economy, but the cause of and management of each is different.
  • Systemic risk is the risk that an event at the company or industry level could trigger a huge collapse, like the 2008 financial crisis.
  • Systematic risk is the risk inherent to the entire market, attributable to a mix of factors economic, socio-political and market-related.

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Written by sortiwa