Financial Literacy Friday: Systematic Risk
Today’s Financial Literacy Friday post is going to dovetail with the previous post on strategic diversification and talk about systematic risk. Systematic risk is risk that affects the entire market or market segment and cannot be diversified away. When people think of market risk they either think of a company or stock taking a hit or something like what happened in 2008-2009 where the whole market took a nosedive. Systematic risk was at play in 2008 as it affected the entire market, so you likely felt it regardless of how you were invested. Unfortunately, this type of risk is impossible to completely avoid and very difficult to predict. Let’s take a look at some of the factors that contribute to systematic risk to see how it can come about.
Systematic Risk Factors
Systematic risk is affected by interest rate changes, inflation, wars, recessions, and other major events that destabilize everyday life. Because these factors cannot be accurately predicted, it’s very difficult to know when the market will react to these events. This type of risk also affects the entire market so simply moving from one company to another or one mutual fund to another won’t reduce the amount of risk your portfolio experiences. Almost everyone remembers the Great Recession of 2008 and how the origin was the bursting of the housing bubble. However, because that bubble popped it led to widespread panic and the markets dropped off a cliff. Because these events created systematic risk, it didn’t simply affect the housing sectors, it spread throughout most facets of the market and people (such as myself) who were invested in other areas in the market saw a sharp decline in the value of their investments. So, systematic risk can strike at any time and is unpredictable and you can’t diversify away from losses, so what can you do to limit its effects?
What To Do?
We talked earlier this week about how diversification throughout market sectors as well as globally is a good way to reduce risk and volatility throughout your investments. Now I’m telling you that there’s a type of risk that doesn’t care how well diversified you are, thrives in an unstable world, and can affect every part of the market. Those with a clear memory of 2008 may elect for the “hide everything under the mattress” strategy, and I can certainly understand where you’re coming from. I would never advocate for that strategy because it doesn’t work even a little, but I get where you’re coming from. So, the biggest thing you can do is make sure that you’re invested in a variety of different asset classes. Stocks, fixed income investments, and cash all react differently to market shifts and there are some investments that do pretty well when systematic risk hits. Making sure that your portfolio is well equipped with a variety of asset classes can help to mitigate some of the damage that may occur, but won’t completely protect you.
However, there is something else you can do that can help your overall returns and prevent you from losing everything, and that is having the right mindset. I know this seems like a cop out, but bear with me. During 2008 I lost something in the realm of $10k in the span of about a week. That was painful as I was counting on that money to help pay for college and having it disappear in a week was demoralizing. However, what seems to get lost in the shuffle of remembering 2008-2009 was that when the market rebounded it kicked off one of the strongest bull markets in recent memory and those that stayed invested and didn’t give in to the fear of lost value made their money back and then some. Being able to understand that systematic risk and recessions happen and are part of the normal market cycle allows you to not give in when this type of adversity rears its head. Obviously having a strategy you believe in and some solid objective advice will greatly help, but knowing that this too shall pass means that it’s likely you’ll come out the other side and be made whole again.
What has been your experience with systematic risk and the Great Recession? Have you been able to avoid selling at the bottom or did you need to get out of the market? I’d love to hear your stories as generation X/Y/Millenials were uniquely affected by this event and our risk tolerance has been greatly reduced because of what happened. Reach out and let me know your story, I’d love to hear how you fared.