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What Is Systemic Risk?

The memory of the 2008 financial crisis and recession is still vivid in our minds, where countless individuals experienced job loss, home foreclosure, and disruption to their lifestyles. Despite multiple factors leading to this economic catastrophe, one overarching concept encapsulates them all: systemic risk. It's essential to understand the implications of systemic risk on investors' actions, so let's delve into its definition and potential impact.

What is Systemic Risk?

As defined by the CFA Institute, systemic risk refers to "the risk of a complete breakdown of a system as opposed to the failure of individual components." This definition can encompass various scenarios, but within the financial industry, it pertains to the possibility of a domino effect of failures across the financial sector. Although every financial system possesses some degree of systemic risk, policymakers aim to mitigate this risk by closely monitoring market movements, evaluating international trends, and implementing regulations that safeguard individuals and their financial assets.

In response to the 2008 financial crisis, the Obama Administration enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. The primary objective of this legislation was to enhance the safety of the US financial system for consumers and taxpayers by creating fresh government agencies tasked with overseeing the financial sector. While it may not be feasible to eliminate all systemic risk, both the government and consumers can adopt measures to prevent a recurrence of a crisis similar to the one that occurred in 2008.2

How Systemic Risk Impacts Investors

Although individual investors cannot entirely shield themselves from systemic risk, examining the concept can offer valuable insights into investing and risk management. For instance, you can leverage current events or conduct research to broaden your investment portfolio and mitigate potential risks.

Apart from analyzing market conditions and trends, systemic risk can motivate us to diversify our assets. Financial experts generally recommend a diversified portfolio that aligns with your risk tolerance level.

While systemic risk and market risk differ, they do prompt the question of "What is an acceptable level of risk?" The response to this query varies based on your 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."3

The notion of the "too big to fail" mentality was one of the contributing factors to the 2008 financial crisis, which highlights the importance of researching individual investment decisions. Relying solely on blind trust, whether it's a large or small company, can be hazardous.

As an investor, comprehending the economy as a whole and the implications of systemic risk on daily life and investments is crucial. The 2008 financial crisis served as a significant wake-up call for both citizens and politicians, emphasizing the significance of effective checks and balances to prevent potential disasters.

However, by implementing thorough oversight, responsible corporate behavior, and informed investors, we can take the necessary steps to shield ourselves from systemic risk. Understanding systemic risk provides investors with valuable insights into the overall impact of risk on their investment portfolios.

  1. https://www.cfainstitute.org/en/advocacy/issues/systemic-risk
  2. https://www.cfainstitute.org/en/advocacy/issues/dodd-frank-rollback
  3. https://www.investopedia.com/terms/s/systemic-risk.asp