Investing in the financial markets is a strategic endeavor where risk and reward dance in a delicate balance. As investors, we often hear about the importance of diversification to mitigate risks and safeguard our portfolios. While diversification is a powerful tool, it's crucial to recognize that not all risks can be eliminated. Systemic risk, in particular, is an inherent threat that remains challenging to diversify away entirely. We all remember the 2008 financial crisis and recession, as millions of people lost their jobs, homes, and ways of life. While a lot of factors contributed to this economic disaster, 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?
Systemic risk refers to the risk of a widespread, often catastrophic, failure within a financial system that can affect the entire market. Unlike unsystemic or idiosyncratic risks, which are specific to individual assets, companies, or sectors, systemic risk transcends these boundaries and impacts the market as a whole. It is the risk of a domino effect, where a shock in one part of the system triggers a chain reaction, potentially leading to a market-wide crisis.
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.
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 US financial system safer for consumers and taxpayers by establishing new government agencies to oversee our financial system. While it's impossible to limit all systemic risk, there are steps that the government and consumers can take to prevent something like the 2008 financial crisis from happening again.
Unsystemic vs. Systemic Risk
One of the fundamental principles of investing is diversification. The idea is to spread investments across various assets, sectors, and geographic regions to reduce the impact of any single negative event. While diversification is effective in mitigating unsystemic risk, it offers limited protection against systemic risk.
Unsystemic risk, also known as specific or idiosyncratic risk, is the risk that is unique to a particular asset, company, sector, or geographical region. By holding a well-diversified portfolio, investors can significantly reduce unsystemic risk, as the performance of one asset or sector is unlikely to have a substantial impact on the entire portfolio.
However, systemic risk operates on a different level. It is the risk associated with the broader economic and financial system, making it impossible to diversify away completely. Factors such as economic recessions, geopolitical events, and financial crises are examples of systemic risks that can have a pervasive impact on all types of assets.
How Systemic Risk Impacts Investors
While individual investors can't 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. 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.
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. 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 US economy made it a source of systemic risk. When the firm collapsed, it "created problems throughout the financial system and the economy."
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 an investor, it's important to understand our economy as a whole and how things like systemic risk impact our daily lives and investments. The 2008 financial crisis was a big wake-up call for Americans and politicians, as we realized that without the proper checks and balances in place, things can go horribly wrong.
But with diligent oversight, responsible companies, and educated investors, we can begin to protect ourselves from systemic risk. Understanding systemic risk is a good way for investors to understand the overall impact of risk on their portfolios.
The Premium for Systemic Risk
Investors are compensated for taking on systemic risk through the risk premium. The risk premium is the additional return that investors demand for holding riskier assets. In other words, the potential for higher returns comes with an acknowledgment of the inherent systemic risks embedded in the investment.
While systemic risk cannot be entirely eliminated, prudent investors aim for full diversification to minimize its impact on their portfolios. This involves not only diversifying across asset classes, sectors, and individual companies but also extending diversification to different geographical areas and currencies.
Diversifying across geographic regions helps protect against country-specific risks, such as political instability, regulatory changes, or currency fluctuations. Likewise, diversifying across currencies provides a hedge against foreign exchange risk, reducing vulnerability to adverse movements in exchange rates.
In the complex world of financial markets, understanding and managing risk is paramount for investors. While diversification is a powerful tool to mitigate unsystemic risk, it is crucial to recognize the limitations when it comes to systemic risk. Investors are compensated for bearing systemic risk through the risk premium, but the goal is to minimize its impact through thoughtful and comprehensive diversification. By embracing full diversification across asset classes, sectors, geographies, and currencies, investors can navigate the uncertain waters of systemic risk more effectively and build resilient portfolios for the long term.
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