While the two terms are almost identical in spelling, there are big differences between systemic and systematic risk. Depending on which of the two you’re looking at and trying to avoid, you may end up taking different approaches to how you invest and what assets you pick for your portfolio.
That doesn’t mean the two are worlds apart. Both are things you need to consider when you invest, because of how they could affect the money that you’re trying to grow.
Systemic risk
Systemic risk is the risk related to the failure of a certain company that negatively affects the industry, sector, or the entire economy. Thus, the origin of this risk is internal. It is also sometimes used in reference to small issues that can cause bigger problems, such as a loss of confidence that leads to a bank run.
If new laws were passed that would make it difficult for a certain industry to remain profitable, that would fall under systemic risk.
There are certain companies and financial institutions which, if they collapsed, would cause a lot of difficulty for a country’s economy through what is known as the ripple effect. These are known as “too big to fail,” and so they’re likely to get government support (to avoid causing bigger issues) if they were in trouble.
For investors, systemic risk can be handled by diversification. Even the largest organizations have a chance of encountering problems, so you shouldn’t put all your money into assets from just a few
entities.
Systematic risk
Systematic risk, on the other hand, refers to the general risk that is always present in the market or market segment. It affects the overall market and is known by other names, including market risk and volatility risk. The origin of this risk is external.
This type of risk is also called non-diversifiable risk because diversification can’t eliminate it. However, asset allocation can mitigate its effects to a certain degree, if you make sure to select from asset classes that respond differently to a major systematic change.
There are many factors to systematic risk, which is why it’s impossible to completely avoid. Events like fuel price surges, large-scale conflicts, and soaring interest rates can all contribute to this risk.
Accepting risk
The possibility of systemic and systematic risks are realities that you need to come to terms with if you want to try to grow your money through investing. That’s why you should never put money in that you can’t afford to lose, in case the worst happens.
Of course, there are ways for you to reduce the chances that your investments will be greatly affected overall by either risk type. Being an investor means understanding these and other risks, and crafting your portfolio accordingly.
