In financial economics, systematic risk usually refers to that type of risk associated to a specific market. This risk stems from the economic, geographical, political, social or other factors of that market. Hence, systematic risk is commonly known as market risk.
How does such a risk affect investors?
A security, such as a bond or equity, contains a risk that is usually represented by price volatility. This risk is made up of two parts, namely, specific risk and systematic risk.
Systematic risk is affected by variables that are related to the entire market while specific risk is related to factors that apply only to that security. For example, if one invests in a bank stock listed in Hong Kong, this investment will be subject to the systematic risk related to the entire Hong Kong stock market, as well as the specific risk related to that bank, such as its earnings outlook, financial stability and so on.
If investors can diversify their holdings into a reasonably large number of securities, the specific risks of individual securities can almost be "diluted" away, and investors will only be exposed to the systematic risk of that market.
Hence, when any event that affects the systematic risk of the market, all securities will be impacted either in the form of a rise or fall in the stock prices. This will apply whether investors hold one single security or a diversified portfolio of securities in that market. As long as they keep their holdings, they cannot avoid being exposed to systematic risk.
How can investors manage such a risk?
Investors should be aware that systematic risk cannot be eliminated, no matter how they diversify their holdings. For individual investors, the best way to manage systematic risk is to control carefully the exposure to risky assets. This means that investors should not invest too much into a single market.
Some experienced investors may choose to use financial derivatives, such as futures and options, to hedge their exposure to systematic risk for a short period of time. However, this method should only be employed if one has a good understanding of how the derivatives work. Even so, this might entail other risks specific to that derivative contract.
Alternatively, investors can consider widening their investment universe by diversifying the systematic risk of their home market. For example, to reduce exposure to the systematic risk of the Hong Kong stock market, investors may consider building a portfolio representative of the global equity markets. Investors with limited money can do so through unit trusts or mutual funds.
(Article contributed by Institute of Financial Planners of Hong Kong)