Systematic Risk

Investment risk comes in two broad kinds. Unsystematic risk is specific to a single company or industry, such as a failed product, a lawsuit or a factory fire. It can be greatly reduced by holding many different investments. Systematic risk affects almost all investments at the same time, so spreading money across more shares does not help much.

Examples of systematic risk include economic recessions, sudden changes in interest rates, high inflation, political crises, wars and pandemics. When a severe recession hits, most share prices tend to fall together.

For example, a portfolio of 500 different companies is well protected if one of them goes bankrupt. But if the whole stock market falls by 30%, that diversified portfolio will still fall by a similar amount.

Because systematic risk cannot be diversified away, investors expect to be paid for bearing it. In models such as the Capital Asset Pricing Model, an asset's exposure to systematic risk, measured by its beta, determines its expected return. Investors can reduce systematic risk only by changing their mix of asset types, for example by holding more bonds or cash.