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Systematic Risk

Definition - What does Systematic Risk mean?

Systematic risk is the risk caused by macroeconomic factors within an economy and are beyond the control of investors or companies. This risk causes a fluctuation in the returns earned from risky investments.

Unsystematic risk, on the other hand, is caused by factors that are within the control of companies such as mismanagement and labor disputes. Both the systematic and unsystematic risk equal total risk.

Divestopedia explains Systematic Risk

Systematic risk includes all of the unforeseen events that occur in everyday life which are beyond the control of investors. The only way to avoid this risk is to avoid investing in any risky investment. However, in the real world, this is not possible because then only T-bills and CDs of government-backed institutions would be the options available for investment. This is why every investor accepts these systematic risks as an integral part of their investment strategy.

To make up for these systematic risks, most investors demand a premium. For example, if the rate of return on a T-bill is 5%, then an investor who is looking to invest in shares expects a 10% return on the investment. This additional 5% is to make up for the systematic risk that can cause the investor to lose money.

In a way, systematic risk can also be seen as an opportunity cost for investing in one investment over another. For example, if an investor has two choices, say, a T-bill that brings in 3% return and a stock that brings in 15% return, then the investor will make a choice based on financial goals and personal preferences. If the investor chooses the first option, then there is no risk involved and the return is low. Also, no systematic risk is involved. On the other hand, if the investor chooses the second option, the return is the opportunity cost on the risk taken by choosing this option over the "safer" option.

While it is not possible to avoid systematic risk altogether, it is possible to reduce its impact by diversifying investments so that even if one investment fails, the return from others will make up for it. In addition, systematic risk can be best mitigated by judicious use of resources and adherence to strict quality control procedures.

In the case of a company sale, systematic risk is pertinent as buyers are likely to offer a lower amount to make up for these risks.

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