Systematic risk, or market risk, is the volatility that affects many industries, stocks, and assets. Systematic risk affects the overall market and is difficult to predict. 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.
Beta and Volatility
Beta is a measure of a stock's volatility in relation to the market. It measures the exposure of risk a particular stock or sector has in relation to the market. If you want to know the systematic risk of your portfolio, you can calculate its beta.
- A beta of 0 indicates that the portfolio is uncorrelated with the market.
- A beta less than 0 indicates that it moves in the opposite direction of the market.
- A beta between 0 and 1 signifies that it moves in the same direction as the market, with less volatility.
- A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility and is sensitive to systematic risk.
- A beta greater than 1 indicates that the portfolio will move in the same direction as the market, with a higher magnitude, and is very sensitive to systematic risk.
Assume that the beta of an investor's portfolio is 2 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 sensitive to systematic risk, but the risk can be reduced by hedging.