What Is Systemic Risk?
We all remember the 2008 financial crisis and recession when millions lost their jobs, homes, and ways of life. While many factors contributed to this economic disaster, one term can cover nearly all of them: systemic risk. Let’s look at systemic risk and how it can impact your behavior as an investor.
What is Systemic Risk?
Systemic risk is the risk of a breakdown of an entire system rather than simply the failure of its individual parts. This could mean a lot of different things, but in finance, it refers to the risk of a cascading failure in an entire industry or economy.1
Any financial system has some level of systemic risk. Still, 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 to respond to the 2008 financial crisis. This legislation aimed to make the U.S. financial system safer for consumers and taxpayers by establishing new government agencies to oversee our financial system. While it’s 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.2
How Systemic Risk Impacts Investors
While individual investors can’t completely protect themselves from systemic risk, the concept does teach us many important lessons about investing and risk tolerance. For example, you can use current events or your personal research to diversify your portfolio and hedge against potential risks.
In addition to analyzing current trends and market conditions, we can use systemic risk as motivation to diversify our assets. Most financial professionals will always recommend a diversified portfolio that is aligned with your personal risk tolerance.
Systemic and market risks aren’t equivalent, but they raise the question: How much risk is too much? The answer to this question depends on your own personal risk tolerance.
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.”1
This risky “too big to fail” ideology is one of the reasons why the financial crisis of 2008 happened, prompting individuals to research their own investment decisions. It’s dangerous to blindly trust any company, big or small, without doing the proper research.
As an investor, it’s essential to understand our economy as a whole and how things such as systemic risk impact our daily lives and investments. The 2008 financial crisis was a big wake-up call for Americans and politicians, as we realized that without the proper checks and balances in place, things could go horribly wrong.
However, with diligent oversight, responsible companies—and educated investors—can begin to protect themselves from systemic risk. Understanding systemic risk is a good way for investors to understand the overall impact of risk on their portfolios.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
