In this post, you will find nine examples for systematic risk. In fact, you can come up with any number of examples provided you understand the meaning of these risks. A risk is said to be Systematic based on its impact on broader markets as a whole. Any risk that affects all invested assets in a market is called a systematic risk.
Another name for systematic risk is a non-diversifiable risk. You will know the reason after reading this post.
In stock markets and other forms of investing, you would have heard a piece of advice time and again. And the advice is to diversify your portfolio so that if an asset fails they’ll be another to balance.
You cannot overcome systematic risks by the act of diversification. The reason is, such risks will affect all underlying assets.
Some major sources of these risks are the following.
- Sweeping changes in government policies
- Changes to Laws
- Natural disasters in a broad geography
Now you will see 9 examples for systematic risks.
1 Changes to Laws
Changes to government policies that affect all sectors are examples of systematic risks. For example, assume that government increases the minimum employee salary by 100%. You know employee cost is a major spend for most of the companies. Hence, such a policy change will affect companies across many sectors. Sure there will be companies with high degrees of automation which escape the crisis. But, when most other companies struggle, there will be widespread layoffs. Hence, the purchasing power of people will decrease. This type of chain reaction will lead to prices of every stock falling. Even if a company sustains margins by employing automation, there could be 3 issues.
- Many investors will not be having enough money to buy further stocks.
- The spending power of the general population will decrease. Thus the company has to reduce the prices of its products.
- An investor who has lost his job will sell the shares for liquid cash.
Hence a major change in employee policy that will have a huge impact on the economy is an example of systematic risk.
2 Tax Reforms
Tax reforms are another source of systematic risks. A tax reform can work in both ways. A reform that reduces the taxes for general public or companies will have a positive impact. But the other way round is also possible. And a systematic risk could result. For example, assume that a government increases the minimum tax slab from 10 % to 30 % for businesses. The increased tax will eat into the margins of the companies.
A tax reform that increases the burden of the general public will have a snowball effect. People will not have enough money to spend on products and services. Hence the companies will have no other way but to reduce the prices. The result will be a decrease in margins which will eventually lead to falling stock prices.
For a risk like tax change to be called a systematic, the impact should be felt across the entire economy. (The tax changes that affect specific segment of people or sectors are not systematic. )
Note. A risk is said to be systematic risk based on its impact on the market not the source of risk.
3 Interest Rate Hikes
Interest rate hikes always make headlines for a reason. The reason is that the impact that will be felt across industries. An increase in interest rates will reduce the number of borrowers from banks. Thus the free money in circulation will decrease. Such changes will lead to an increase in inflation. An increase in inflation beyond a certain limit is not good for the economy. Major hikes in rates will take place as a result of unavoidable circumstances like huge fall in inflation. Such changes will have an avalanche effect on the economy and markets as a whole. Impactful rate hikes are perfect examples for systematic risks.
4 Natural Disasters (Earthquakes, Floods, etc.)
One cannot control the nature. Natural disasters in specific regions do not have a major impact on the whole market. But, disasters that affect an entire country will affect most organizations in the region. Even if a company is not purely a brick and mortar business still it will have an office space and employees working on the ground. So the impact will be widespread.
Due to the advanced warnings systems, natural disasters are not a very serious threat to markets. However, think of an underdeveloped economy that has an area much smaller than big counterparts. In such a case, natural disasters will have a defining impact on the indexes of that country. Almost all sectors in the region will face the ire of mother nature. Such risks are called systematic risks.
5 Political Instability and Flight of Capital
Political instability is a major risk faced by companies in many countries. (This risk is nonexistent in countries with stable governments.) There are countries in the world that are perennially in a state of political instability. In such cases, the markets may be in good shape for short periods of stability. But once risk from political sources is sensed there will be a large-scale flight of capital.
6 Changes to Foreign Policy
An example of how policy change can turn into a systematic risk is Brexit. Foreign policy changes like Brexit will obviously have a deep impact on the economy as a whole. For example, post-Brexit, every company in the UK are rethinking the strategy. They have to rework future plans right from scratch. They may need to sign new papers with European countries. Thus companies need to adapt to the changing market conditions. Foreign policy changes as big as Brexit are examples of systematic risks.
Chages like protectionism measures by powerful economies will have a cascading effect on trading partners. For example, even slight changes to policy by huge economies like China will affect most of its importing partners. (You know China is one of the biggest exporters in the world.)
There are countries which are dependent on tourism for their economic development. Assume that large countries warn people preventing them from touring a certain country. Such a move will have an impact on the host country as a whole. Such warnings are issued either due to political instability, civil unrest or spread of diseases.
7 Currency Value Changes
No country operates in isolation. A country’s economy is highly dependent on its healthy trade with the other countries. Huge changes to the currency value will affect the economy as a whole and is an example of systematic risk. Usually, big changes to the currency values are a result of some other major changes like change in foreign policies. Even huge tax reforms may lead to currency value changes.
8 Failure of Banks (e.g. 2008 Mortgage Crisis)
Economy of a country is dependent on the health of the banking system. Majority of businesses need credit for their operations. Also, the interest rate should not be a burden during repayment. What if the banks fail? For example, remember the mortgage crisis of 2008 (since the collapse of Lehman Brothers). The crisis was felt across the entire banking industry. The collapse of the banking system was one of the major causes of the recession. The impact of recession was widespread, Almost all benchmarks dropped. The recovery was only after about 2 years. During the recession, there could be few winners (outliers) here and there, but in general, the risk was systematic.
9 Economic Recessions
There can be multiple reasons for recessions. They may be due to a failure of banking systems, bubble due to overvaluation in big markets, conflicts between countries, etc.
There were at least 11 economic recessions in the US since 1948. And every time major benchmark indexes fell which indicates the deep impact of the recession on the economy.
Conclusion: Why Context is Important for a Systematic Risk
When talking about systematic risks, the context is important. A risk that looks widespread when observed from one country may look different from another country. For example, even during the recession of 2008 to 2010 developing economies like India and China performed far better than the rest. The impact of the recession was minimal for those countries.
The frame of reference is important to judge if a risk is systematic or not. For example, let there be two countries ‘A’ and ‘B’ that have trading ties with the US. Let ‘A’ be completely dependent on US (based on exports) while ‘B’ has only a partial exposure to the US markets. Let some policy changes of US reduces the trading volume of US with both ‘A’ and ‘B’. For example, a high duty on imports may negatively affect the exports from either of the countries to the US. Now let us observe the risk relative to both ‘A’ and ‘B’. If your frame of reference is ‘A’, then you can call the risk to be systematic. But for B, only a handful of companies may be affected. Hence, from the perspective of B, the risk may not be systematic.
Hopefully, the examples have helped you understand a nondiversifiable risks. If you are not sure whether a risk is a systematic or not just ask this question to yourself. If you can eliminate or balance your negative impacts if you have a diversified portfolio then that risk is unsystematic. however, even if you have a diversified portfolio but still cannot escape a risk, then it is systematic.