What is Systemic Risk and Unsystemic Risk

personal financeThere is a lot of talk in the investment industry about how investors need to be aware of the systemic risk that they are taking into their portfolios, and take measures to reduce the amount of unsystemic risk they are exposed to overall. That being said, to the average investor, this sort of investment gibberish doesn’t help anyone protect their personal wealth by much at all. Combined with the way in which investment securities all seem to trade with nearly perfect correlation, it can be pretty difficult to determine what kind of risk is avoidable, and what kind of risk is going to be associated with every aspect of an investment portfolio at once.

Unsystemic risk is the risk that an investor takes on that is reasonably exclusive to that particular investment’s operations. For example, an investment into a coal mining stock will not likely be exposed to many of the same risks as a clothing retailer. However, both of these companies will be exposed to the greater risks associated with changing interest rates. The risks that are taken on only through the coal company are unsystemic, because they are exclusive to a particular investment, while the systemic risks are those that are faced by all companies overall.

Systemic risks are considered to be inevitable because of the way in which an investor will face them regardless of the composition of their portfolio. Alternatively, an investor can reduce their exposure to company-specific unsystemic risks by spreading out their exposure across multiple different companies in a portfolio.

Looking back at our example of the retailer and the coal producer, the best way to visualize systemic risk is by looking at a portfolio that is made up of only these two investments. If an investment portfolio consists of entirely of only the coal mining company, the investor is 100% exposed to the systemic of that company. However, by splitting the portfolio so that it is half coal mining and half clothing retailer, the portfolio is only 50% exposed to the systemic risks of the coal company, and then 50% exposed to the risks of the fashion company.

This means that a sudden drop in the price of coal will have half of the impact that it would have had otherwise, and might be offset by the fact that people are still buying clothing from the retailer. However, on the other side of the equation, the portfolio is now only exposed to 50% of the upside associated with the coal company, meaning that a jump in the price of coal will only have half as much of a benefit as it would have otherwise. This is where we start to see how it is that the overall portfolio is evening out its risk level in a way that keeps its risks and rewards tied more to overall systemic risks, as opposed to sudden unsystemic risks.

With respect to our portfolio of a coal miner and clothing retailer, both positions are going to move up and down as a result of their own company-specific risks and operations. However, both positions are going to generally move in conjunction with the over-arching economy. For example, if interest rates decrease, both companies are going to have better access to debt financing, and will therefore have cheaper operating costs as a result. Both companies will therefore have an improved ability to perform.

Alternatively, if interest rates increase, both companies will be harmed by the change in their costs of capital. This shows how it is that we are instead more exposed to the systemic risk of the overall economy than we were the company specific risks of each position.