*Disclaimer: Any Information found on website is for education purposes and is not tailored to the investment needs of any specific investor. Investing involves risk, including risk of loss.
No matter how diverse a portfolio is, you can’t diverse away from a systematic risk. A systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities regardless of the company’s circumstances. An individual securities can be stocks, bonds, etc from a particular company. It is usually caused by certain factors that affect all businesses, such as war, global security threats, or inflation.
What are the most common systematic risks?
A market risk is the risk that when the overall market declines, so will any portfolio made of securities. All retirement accounts are made of securities and will be affected by the market. For instance, if the Dow Jones Industrial Average or any other market index were to decrease drastically, so would a portfolio made of common stock.
Interest Rate Risk
Interest rate risk is defined as a potential change in bond prices caused by change in market interest rates after an issuer offers its bond. For instance, if interest rates rise after being issued, existing bonds (with a lower coupon) will be viewed less attractive and will be priced in the market at a discount. As you can see, there is an inverse relationship between the direction of rates and bond price moves.
If a bond has a long duration, if rates move up or down, the prices of bonds with lower maturities will fluctuate more than bonds with shorter maturities. Duration is a term used to describe a bond’s price sensitivity to interest rate swings.
If the Federal Reserve push interest rates higher, the market price of all bonds will be affected. When interest rates rise, the market price of bonds falls, and that is why this is a systematic risk for fixed-income securities.
A reinvestment risk is defined as a risk that is a result of variation of interest rates. For instance, when interest rates decline, it will be difficult to reinvest proceeds from a bond/security when called by an issuer, or investment distributions and maintain the same level of income without increasing credit or market risks.
Inflation Risk (Purchasing Power Risk)
Purchasing power risk or inflation risk is the effect of continuous rising of prices on investment returns. If an investments yield is lower than the inflation rate, the purchasing power of the client’s money decreases over time. This simply means that the money we have today will not be able to buy the same amount of goods of services in the future since prices will increase.
Overall systematic risk is something that affects all businesses and the overall market. We can’t diverse our portfolio against this no matter how we try.