When you’re new to trading, it’s easy to focus only on potential profits. However, understanding risk is just as important. In trading, there are two main types of risk to consider: systemic risk and non-systemic risk. Knowing the difference between these risks can help you make smarter decisions and protect your investments.
In this article, we’ll explore what systemic and non-systemic risks are, how they impact your trades, and strategies to manage them. By the end, you’ll have a solid understanding of how these risks affect trading and how to manage them for long-term success.
What is Risk in Trading?
Risk is the chance of losing money on an investment. In trading, every decision comes with some level of risk. While it’s impossible to eliminate risk entirely, understanding the types of risk involved can help you make better trading choices and protect your portfolio.
There are many risks in trading, but they can be broadly divided into two categories:
- Systemic Risk: The risk that affects the entire market or economy.
- Non-Systemic Risk: The risk that affects only a specific company or industry.
Let’s take a closer look at each type and how they impact your trading.
Systemic Risk
Systemic risk (also known as market risk) is the risk that affects the entire financial system or economy. It is caused by events that impact all businesses and industries, such as economic downturns, natural disasters, or political events. Because systemic risk impacts the entire market, it’s difficult to avoid, even with a diversified portfolio.
Examples of Systemic Risk
Here are some common causes of systemic risk:
- Economic Recessions: During a recession, businesses make less money, unemployment rises, and consumer spending decreases. This can cause stock prices to fall across the entire market.
- Interest Rate Changes: Central banks, like the Federal Reserve, change interest rates to control inflation. Higher interest rates make borrowing more expensive, which can slow down the economy and reduce stock prices.
- Political Instability: Events like elections, trade wars, or conflicts can create uncertainty, causing markets to drop.
- Natural Disasters: Major events like earthquakes, hurricanes, or pandemics can disrupt global supply chains and reduce economic activity.
When systemic risks occur, they can affect nearly every asset in the market, making it challenging for traders to find “safe” investments.
How Systemic Risk Impacts Trading?
Systemic risk can lead to large losses across your entire portfolio. For example, if there’s an economic recession, even strong companies may see their stock prices fall. Bonds, commodities, and other assets can also be affected, as traders become cautious and reduce their investments.
For traders, systemic risk means that even a well-diversified portfolio can suffer during a market downturn. It’s essential to understand that systemic risk is beyond your control, and it affects everyone in the market.
Non-Systemic Risk
Non-systemic risk (also known as specific risk or idiosyncratic risk) is the risk that affects only a particular company or industry. Unlike systemic risk, non-systemic risk can be reduced or even eliminated through diversification. It’s based on factors unique to individual businesses or sectors, rather than the entire market.
Examples of Non-Systemic Risk
Here are some common causes of non-systemic risk:
- Company-Specific Issues: Problems like poor management decisions, product recalls, or legal issues can cause a company’s stock price to fall, even if the broader market is stable.
- Industry-Specific Risks: Industries can face unique risks. For example, the energy industry is highly sensitive to oil prices, while the technology sector may be impacted by changes in regulation or innovation.
- Competition: A company may lose market share if a competitor launches a better or cheaper product. This risk is specific to the company and doesn’t affect the entire market.
- Financial Problems: If a company has high debt, it may struggle during difficult economic times. This risk affects the company specifically, rather than the broader market.
Non-systemic risks are often avoidable by spreading your investments across different companies and industries, which reduces the impact of any one asset’s performance on your overall portfolio.
How Non-Systemic Risk Impacts Trading?
Non-systemic risk means that individual stocks or sectors may perform poorly, even if the overall market is doing well. For example, if a company reports poor earnings, its stock may drop, even if the economy is growing. Similarly, a pharmaceutical company facing a lawsuit may see its stock fall, while the broader healthcare sector remains stable.
For traders, non-systemic risk highlights the importance of diversification. By investing in different sectors and assets, you can reduce the impact of a single stock or industry’s poor performance on your portfolio.
How to Manage Systemic and Non-Systemic Risk?
Managing risk is a critical part of successful trading. Here are some strategies to help you handle both systemic and non-systemic risks:
- Diversify Your Portfolio: Diversification involves spreading your investments across different assets, sectors, and regions to reduce the impact of any single risk. While diversification can’t eliminate systemic risk, it helps reduce non-systemic risk.
Example: If you invest in technology stocks, consumer goods, and real estate, a problem in the tech industry won’t have as large an impact on your overall portfolio. - Use Asset Allocation: Asset allocation is the process of dividing your investments among different asset classes, like stocks, bonds, and commodities. By holding a mix of assets, you can reduce the impact of systemic risk on your portfolio.
Example: During a market downturn, stocks may fall, but bonds or gold might perform better, balancing your losses. - Monitor Economic Indicators: Systemic risks often come from changes in the economy. By following economic indicators like interest rates, inflation, and unemployment, you can anticipate market shifts and adjust your strategy accordingly.
Example: If inflation is rising, you might shift some of your investments to commodities, like gold, which tend to hold value during inflation. - Set Stop-Loss Orders: A stop-loss order is an instruction to sell a stock if its price drops to a certain level. Stop-loss orders can protect you from severe losses caused by both systemic and non-systemic risks.
Example: If you set a stop-loss order 10% below the current price, your stock will automatically sell if it falls by 10%, limiting your losses. - Stay Informed: Keep up with news and market trends. Understanding what’s happening in the economy and specific industries can help you manage both types of risk. For example, if a company faces a significant lawsuit, you may want to sell its stock to avoid losses from non-systemic risk.
Examples of Systemic and Non-Systemic Risk in Action
Let’s look at a few examples to understand how these risks affect trading.
- Example 1: Systemic Risk: Imagine a global recession hits, and stock prices fall across all sectors. Even companies with strong finances see their stock prices drop because of the broader economic downturn. This is systemic risk because it affects the entire market, and traders can’t avoid it completely.
- Example 2: Non-Systemic Risk: Now, let’s say a specific tech company faces a security breach that harms its reputation. As a result, its stock price drops, even though other tech stocks remain stable. This is non-systemic risk because it’s specific to that company. If you have a diversified portfolio, the impact on your overall investments may be limited.
Final Thoughts
Understanding systemic and non-systemic risk is essential for anyone entering the world of trading. Systemic risk impacts the entire market and is unavoidable, while non-systemic risk affects specific stocks or industries and can be managed with diversification. By learning to identify and manage these risks, you can make smarter trading decisions and protect your portfolio.
Risk is a natural part of trading, but with the right strategies, you can reduce its impact and improve your chances of success. Remember, knowledge and preparation are your best tools for navigating the ups and downs of the market. With a clear understanding of systemic and non-systemic risks, you’ll be well-equipped to handle whatever the market brings.