Systematic risks

These risks affect the entire market or broad segments of the market and cannot be diversified away.

The North American Securities Administrators Association (NASAA) exam outline specifically names three systematic risk examples: interest rate risk, sector risk, and geopolitical risk. These are the highest priority concepts to master.

Understanding Systematic Risk

  • Systematic risk is the risk that broad market or economic factors cause the value of investments to decline regardless of individual company performance
  • Also called market risk or non-diversifiable risk
  • Affects the entire market or large segments of it simultaneously
  • Cannot be eliminated through diversification - only hedging or asset allocation can mitigate it
  • Measured by beta (beta of 1.0 = moves with the market; beta > 1.0 = more volatile than the market)

Exam Tip: Gotchas

  • Systematic risk CANNOT be diversified away. The exam tests whether you know the difference between risks that diversification eliminates (unsystematic) and risks that persist no matter how many securities you hold (systematic). Interest rate risk and inflation risk are systematic; they affect the entire bond market, not just one issuer.

Interest Rate Risk

The risk that changes in interest rates will reduce the value of fixed-income investments.

  • Inverse relationship: When interest rates rise, bond prices fall (and vice versa)
  • Affects all fixed-income securities regardless of credit quality
  • Longer maturity and lower coupon = greater sensitivity to interest rate changes

Why does this happen? Imagine you own a bond paying 5% interest. If new bonds start paying 7%, nobody wants your 5% bond at full price. You'd have to sell it at a discount. That's why rising rates push bond prices down.

Key Point: Having a diversified portfolio of bonds doesn't help because all bonds decline when rates rise.

Exam Tip: Gotchas

  • Longer maturity + lower coupon = greatest interest rate sensitivity. The exam frequently asks which of two bonds is more sensitive to a rate change; choose the one with the longer maturity, and if maturities match, the one with the lower coupon.

Market Risk

The risk that the overall stock market declines, dragging down most securities regardless of individual merit.

  • Represents broad market movements that affect virtually all stocks simultaneously
  • Cannot be eliminated through diversification

Inflation Risk (Purchasing Power Risk)

The risk that rising prices erode the real return on investments.

  • Also called purchasing power risk
  • Fixed-income securities are most vulnerable because their payments are fixed in nominal terms
  • Example: If a bond pays 4% but inflation is 5%, the real return is negative 1%

Exchange Rate Risk (Currency Risk)

The risk that changes in foreign currency exchange rates reduce the value of international investments when converted back to domestic currency.

  • Also called currency risk
  • Applies to any investment denominated in a foreign currency (foreign stocks, bonds, real estate)
  • Example: You buy a European stock. The stock rises 10% in euros, but the euro falls 15% vs. the dollar. Your U.S. dollar return is negative
  • Cannot be eliminated through diversification across multiple foreign investments (if the U.S. dollar strengthens broadly)

Sector Risk

The risk that an entire industry or economic sector declines due to macroeconomic conditions.

  • Affects all companies within the same industry, regardless of individual company quality
  • Examples:
    • Energy sector decline from falling oil prices
    • Real estate sector decline from rising rates
  • Cannot be eliminated by diversifying within a sector; owning five different bank stocks still leaves full exposure to sector risk

Why it is systematic: A single regulatory change or commodity price shock can sweep through an entire industry simultaneously, just as a market crash sweeps through all stocks. Sector risk affects a broad swath of securities beyond any one company.

Geopolitical Risk

The risk that wars, political instability, sanctions, trade disputes, or changes in international relations cause broad market declines.

  • Can affect broad markets (e.g., war between major powers) or specific regions/countries
  • Cannot be eliminated through diversification if the event affects the entire market or multiple markets simultaneously

Why it is systematic: Major geopolitical events can cause widespread market declines that affect many asset classes and countries at once, regardless of individual security fundamentals.

Reinvestment Risk

The risk that cash flows (coupons, principal) must be reinvested at lower prevailing rates when interest rates fall.

  • When a bond matures or pays a coupon during a period of declining rates, the investor may not be able to earn the same return on the reinvested funds

Memory Aid: PRIME

Use the PRIME acronym to remember the systematic risk types:

  • P - Purchasing power (inflation risk)
  • R - Reinvestment risk
  • I - Interest rate risk
  • M - Market risk
  • E - Exchange rate (currency risk)