We all remember the 2008 financial crisis and recession, as millions of people lost their jobs, homes, and ways of life. We are also standing in the wake of the covid pandemic, an inflationary environment, and looking at a potential coming recession. While a lot of factors contributed to these economic disasters, one term can cover nearly all of them: systemic risk. Let's look at what systemic risk is and how it can impact your behavior as an investor.
What is Systemic Risk?
According to the CFA Institute, systemic risk is "the risk of a breakdown of an entire system rather than simply the failure of individual parts." This could mean a lot of different things, but in finance, it refers to the risk of a cascading failure in the financial sector.1
Any financial system has some level of systemic risk, but policymakers seek to limit this risk by closely monitoring the market, analyzing global trends, and creating reforms to help protect people and their finances.
For example, the Obama Administration signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law in July 2010 as a response to the 2008 financial crisis. The idea behind this legislation was to make the U.S. financial system safer for consumers and taxpayers by establishing new government agencies to oversee our financial system.2 Whether these legislation moves worked or not, it's impossible to erase all systemic risk. While governments can try to legislate their economies to decrease the risks facing their economies, it does not take systemic risk away, and poor policy can create even more systemic risk. This example of systemic risk is taken from the U.S. system and is an important point to make that each economic system holds its own risks. Although it will be stressed throughout this blog, it is important to note that no one system can be free of risk; rather, there are systems that hold more or less, or simply different risks. Learning how you, as the investor, can take steps to build a portfolio that seeks to reduce this risk is what will be important for you in finding solutions for your financial situation.
How Systemic Risk Impacts Investors
While individual investors can not protect themselves from systemic risk completely, looking at the concept does teach us a lot of important lessons about investing and risk tolerance. For example, you can use current events or your personal research to diversify your portfolio and hedge against potential risks. Understanding systemic risk will allow you to understand that not all systems are the same, and some while holding opportunities may be quite risky, and others may offer a more stable environment for your wealth structure, investments, and even currency holdings. It is up to you as the investor to determine what amount of risk you are willing to take on.
In addition to analyzing current trends and market conditions, we can use systemic risk as motivation to diversify our assets. Most financial professionals will always recommend a diversified portfolio that's aligned with your personal risk tolerance. But when talking about diversification, one needs to remember that diversification does not just include holding investments in different sectors of the marketplace but looking for foreign currencies and economies that will be less affected by the systemic risk of the U.S. economy. As an example, inflation was a systemic risk that took hold of the U.S. economy for various reasons and saw its peak of 9.1% in 2022, having massive effects on the value of the USD and the economy. While inflation now stands at around 3% (still high but better), we can look to the country of Switzerland and the Swiss Franc (CHF) for an example of a country that was able to navigate the inflationary environment much better with inflation hitting a high of 3.5% in 2022 and is now at 1.7% (target inflation for Switzerland is 0-2% YoY).4 The U.S. economy is now drawing closer to its target inflation of 2%, but it is still high. The picture this paints for the investor is that the Swiss economy was less affected by the systemic risk than the U.S. economy. The purchasing power of the USD was much more affected than that of the Swiss franc.
Systemic risk and market risk aren't equivalent, but they do raise the question, "How much risk is too much?" The answer to this question depends on your own personal risk tolerance.
What Investors Can Do
Looking at systemic risk also makes us more skeptical of companies that are "too big to fail." For example, Lehman Brothers' "size and integration" into the U.S. economy made it a source of systemic risk. When the firm collapsed, it "created problems throughout the financial system and the economy."3 This risky "too big to fail" ideology is one of the reasons why the financial crisis of 2008 happened, prompting individuals to do research on their own investment decisions. It's dangerous to blindly trust any company, big or small, without doing the proper research. As seen in 2022, as the FED raised interest rates, the banks felt the pressure, which led to some of their collapses, i.e., inflation, and dealing with it led to a systemic failure in the U.S. But let's take it one step further; understanding systemic risk allows the investor to assess the economy they hold their investments in and determine if they are healthy or unhealthy environments. The U.S. government just raised the debt ceiling from 31.4 trillion dollars to nearly 34 trillion dollars. The U.S. debt to gross domestic product (the amount of money its economy generates in a year) stands at 129%.5 This is an astronomical number, and investing in a company with this amount of debt may cause some investors to wriggle because what happens if a default were to happen? It would cause catastrophic system failures and the loss of the value invested in that environment.
If we look at a country like Switzerland, a different picture emerges. The alpine country has a debt limit of 43% of its gross domestic product (GDP). This means that if they want to increase spending, they can not simply increase their debt. They have to cut it from somewhere else. Swiss debt to GDP stands at around 41% right now. In the two cases, it is important to see a stark difference between the two economies, and it further highlights why many Americans look to take advantage of the Swiss financial service industry for solutions to hold a portion of their wealth and build a diversified portfolio. While it does not 100% reduce systemic risk, it can allow for an environment for Americans to create a nest egg and reduce the systemic risk of the U.S. economy while bringing true diversification to their portfolio.
If you want to learn more about the benefits of working with a Swiss asset manager, check out the blog post "Moving Offshore: A Strategic Decision For Americans."
As an investor, it's important to understand the U.S. economy as a whole and how things like systemic risk impact our daily lives and investments. It also allows the investor to learn what steps they can take to protect their wealth and reduce the systemic risk the U.S. economy poses to their holdings.
With diligent oversight, responsible companies, and educated investors, Americans can be better prepared to protect themselves from systemic risk. Understanding systemic risk is a good way for investors to understand the overall impact of risk on their portfolios and the differences between economies and the levels of systemic risk.
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