Systematic risk, or total market risk, is the volatility that affects the entire stock market across many industries, stocks, and asset classes. Systematic risk affects the overall market and is therefore difficult to predict and hedge against. Unlike with unsystematic risk, diversification cannot help to smooth systematic risk, because it affects a wide range of assets and securities. For example, the Great Recession was a form of systematic risk; the economic downturn affected the market as a whole.
Investors can still try to minimize the level of exposure to systematic risk by looking at stock's Beta, or its correlation of price movements to the broader market as a whole. Here, we take a closer look of how beta relates to systematic risk.
- Systematic risk cannot be eliminated through diversification since it is nonspecific risk that affects the entire market.
- The beta of a stock or portfolio will tell you how sensitive your holdings are to systematic risk, where the broad market itself always has a beta of 1.0.
- High betas indicate a greater sensitivity to systematic risk, which can lead to more volatile price swings in your portfolio, but which can be hedged somewhat.
Beta and Systematic Risk
Beta is a measure of a stock's volatility in relation to the market. It essentially measures the relative risk exposure of holding a particular stock or sector in relation to the market.
If you want to know the systematic risk of your portfolio, you can calculate its beta. Beta effectively describes the activity of a security's returns as it responds to swings in the market. A security's beta is computed by dividing the product of the covariance of the security's returns and the market's returns by the variance of the market's returns over a specified period, using this formula:
Beta coefficient(β)=Variance(Rm)Covariance(Re,Rm)where:Re=the return on an individual stockRm=the return on the overall marketCovariance=how changes in a stock’s returns arerelated to changes in the market’s returnsVariance=how far the market’s data points spreadout from their average value
Note that beta can also be calculated by running a linear regression on a stock's returns compared to the market using the capital asset pricing model (CAPM). In fact, this is why this measure is called the beta coefficient, since statitsticians and econometricians label the coefficients of explanatory variables in regression models as the Greek letter ß. The formula for CAPM is:
What Does Beta Tell You?
Once you've calculated the beta of a security, it can then be used to tell you the relative correspondence of price movements in that stock given price movements in the broader market as a whole.
- A beta of 0 indicates that the portfolio is uncorrelated with the market. In other words, movement of the stock or stocks held move randomly in relation to the broader market.
- A negative beta (i.e. less than 0) indicates that it moves in the opposite direction of the market and that there is a negative correlation with the market.
- A beta between 0 and 1 signifies that it moves in the same direction as the market, but with less volatility -- that is, smaller percentage changes -- than the market as a whole.
- A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility and is sensitive to systematic risk. Note that the S&P 500 index is often used as the benchmark for the broader stock market and the index has a beta of 1.0.
- A beta greater than 1 indicates that the portfolio will move in the same direction as the market, and with a higher magnitude that the market. Stocks with betas above 1.0 are quite sensitive to systematic risk.
In reality, you won't have to go about calculating beta yourself in most cases. Beta is commonly listed on freely available stock quotes from several online financial portals, as well as through your broker's website.
Assume that the beta of an investor's portfolio is 2.0 in relation to a broad market index, such as the S&P 500. If the market increases by 2%, then the portfolio will generally increase by 4%. Likewise, if the market decreases by 2%, the portfolio generally decreases by 4%. This portfolio is therefore sensitive to systematic risk, but the risk can be reduced by hedging. This can be achieved by obtaining other stocks that have negative or low betas, or by using derivatives to limit downside losses.