As if the impact of COVID-19 on public health was not scary enough, the new coronavirus has also been a plague on the global marketplace. Around the world, stock markets are taking a hit. People are (understandably) concerned about what the new virus means for their health as well as their finances. In the midst of so much uncertainty, what can we learn from the coronavirus about systematic risk?
What is systematic risk?
You have probably heard several other names for systematic risk on the news or on your favorite talk show — “volatility,” “market risk,” or “undiversifiable risk.” All of these terms refer to the inherent overall risk in the marketplace.
Systematic risk is the risk that unpredictable and unavoidable crises (like wars, natural disasters, or epidemics) can affect multiple industries all at once. Unlike other forms of risk in the marketplace, systematic risk cannot be avoided by diversifying your portfolio.
Take the COVID-19 pandemic, for example. How has the virus impacted your life directly?
Quarantine measures and worries about the virus’s spread have drastically impacted the way we go about our daily lives. Concerts and sporting events have been canceled. Travel restricted. Schools closed. People are staying home instead of going out to eat and spend money at movie theaters, amusement parks, and malls. It’s hard to think of an industry that hasn’t been negatively affected by the coronavirus.
Systematic risk vs. Unsystematic risk
While systematic risk cannot be avoided when an unforeseen crisis affects the marketplace, unsystematic risk can be avoided.
Unsystematic risk can be thought of as the risk you take by putting all your eggs in one basket. Imagine you invest all of your money into an up-and-coming dating app for dogs, and the app flops. Suddenly, you’ve lost all the money you’ve invested. You could have avoided a complete loss by diversifying your investment — putting each egg into a different proverbial basket. You might choose to branch out from the app industry to include energy, communication services, and consumer staples in your portfolio.
Let’s take our hypothetical situation back to the current coronavirus crisis. While your dog might not be swiping right much while they’re in canine quarantine, most other industries like entertainment, travel, and energy won’t be faring much better than dog dating apps. In this case, you couldn’t have avoided losing money by investing your money elsewhere because every industry is taking a hit.
See the difference? Systematic risk puts all the proverbial baskets (and eggs) at risk, while unsystematic risk threatens just a few.
How to minimize the systematic risk of my investments during a crisis?
We get it. When it comes to your retirement fund, you don’t want to take any chances. To curtail the risk on your investments, the first thing you will want to do is make sure that you minimize your unsystematic risk, since that is the type of risk you can control (get ready to redistribute some eggs!).
Second, it’s a good idea to take a look at the beta value of your investments. Economists use beta (B) values to measure how risky a given financial asset is relative to the risk of the overall market. The baseline of the market overall is measured at 1. Therefore, if B > 1, that means that a particular asset is more risky than average market volatility. A value of B < 1 means that it islessrisky than the market.
How much risk you should take on (and thus what beta values your investments should have) will depend upon your personal financial situation. If you’re getting ready to retire soon and you’re worried about what a crash in the market would do to your retirement fund, you might want to aim for assets with B < 1, like government bonds. But if you’re young or are willing to take a gamble for a higher potential return, you may consider adding a few more B > 1 investments to your portfolio.
Finally, to mitigate your systematic risk, you’ll want to diversify the types of assets in which you invest. This doesn’t mean just investing in different industries within the stock market, but rather investing in a combination of bonds, exchange-traded funds (a package of securities that you buy together), real estate, commodities, certificates of deposit (CDs), and foreign securities.
Since each of these assets responds differently to economic downturns, you will have more security than if you were invested in the stock market alone.
The bottom line
What’s the bottom line? Investing money is an inherently risky business. Anytime you invest money into a financial venture, you are taking on systematic risk and making a gamble that you might not get the money back if the venture fails. But does that mean that the risk is not worth the return? Absolutely not! Smart investing is one of the best ways to improve your financial fitness.
If the last 100 years have taught us anything, it is that (at least in terms of the market) what goes down must come back up (eventually). Just five years after The Great Recession of 2008, the Dow Jones Industrial Average surpassed its pre-recession value. So, if the coronavirus has you worried about the state of the stock market, it’s not time to panic about your investments yet. Remember that slow and steady wins the investment race.
For further tips to keep your financial health strong, be sure to check out the rest of the Academy library!