We all remember the 2008 financial crisis and recession, as millions of people lost their jobs, homes, and ways of life. While a lot of factors contributed to this economic disaster, one term can cover nearly all of them: systemic risk. Let us look at what systemic risk is and how it can impact your behavior as an investor.
What is systemic risk?
According to the CFA Institute, systemic risk is "the risk of a breakdown of an entire system rather than simply the failure of individual parts." This could mean a lot of different things, but in finance, it refers to the risk of a cascading failure in the financial sector that is not limited to one institution. Any financial system has some level of systemic risk, but policymakers seek to limit this risk by closely monitoring the market, analyzing global trends, and creating reforms to help protect people and their finances.
For example, the Obama Administration signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in July 2010 as a response to the 2008 financial crisis. The idea behind this legislation was to make the US financial system safer for consumers and taxpayers by establishing new government agencies to oversee our financial system. While it is impossible to limit all systemic risk, there are steps that the government and consumers can take to prevent something like the 2008 financial crisis from happening again.
How systemic risk impacts investors
While individual investors cannot protect themselves from systemic risk completely, looking at the concept does teach us a lot of important lessons about investing and risk tolerance. For example, you can use current events or research to diversify your portfolio and hedge against potential risks, or even take advantage of them. In addition to analyzing current trends and market conditions, we can use systemic risk as motivation to diversify assets. Most financial professionals will always recommend a diversified portfolio that is aligned with your personal risk tolerance.
Systemic risk and market risk are not equivalent, but they do raise the question, "How much risk is too much?"
The answer to this question depends on your own personal risk tolerance. Risk tolerance is not the same as your risk comfort level. You may be uncomfortable when things are not going up consistently. (Everyone is. That is not special or unique to you). What is more important than your general feelings of discomfort with investing during uncertain times is matching the degree of risk that you are willing to endure given the volatility in the value of an investment with your actual financial goals. How much risk can you afford to take and how much risk makes sense for what you are truly trying to accomplish? Are the things you are investing in too risky? Are you taking on enough risk, keeping in mind that too little risk might also mean missing out on long term returns and not meeting your goals or keeping up with inflation over time?
Looking at systemic risk also makes us more skeptical of companies that are "too big to fail."
For example, Lehman Brothers' "size and integration" into the US economy made it a source of systemic risk. When the firm collapsed, it "created problems throughout the financial system and the economy." This risky "too big to fail" ideology is one of the reasons why the financial crisis of 2008 happened, prompting individuals to do research on their own investment decisions. It is dangerous to blindly trust any company, without doing the proper research. Larger companies may have greater cash runways than smaller or regional banks, for example, but they still need to focus on risk mitigation just like every other firm working in finance right now. Thankfully, as investors, we do have the FDIC and SIPC assisting in the event of bank or brokerage firm failures to help protect us, however, dealing with that process can be timely.
As an investor, it is important to understand our economy as a whole and how things like systemic risk impact our daily lives and investments.
With diligent oversight, responsible companies, and educated investors, we can work to mitigate risk in portfolios when we stay focused on things within our control. For example: understanding FDIC and SIPC insurance, diversifying your investments and understanding how risk plays into your own portfolio. There is no perfect investment that will win every year without tradeoffs. Ask questions and get comfortable with the fact that systemic risk is present in all things. Now is a great time for investors to understand the overall impact of risk on your portfolio. If you have questions about your own portfolio or would like us to complete a risk assessment or stress test of your investments for you, reach out for assistance.