Understanding Systemic Risk

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Every time you buy a stock, you are taking on risk. It’s all part of the game. You take on risk in the hope or reaping the reward. Some traders win when they take on this risk, but at the same time some traders lose too. It is important that you understand the chief risks that will confront you as a trader so that you can take steps to contain them as much as possible.

[VIDEO] Understanding Systemic Risk

Understanding key risks enables you to counteract forces that are unhelpful to the prices of your shares and minimize the impact of those forces on your investments’ profitability.

Let’s talk about one of those risks: systemic risk.

Systemic Risk

Systemic risk, as the name implies, is the inevitable consequence of operating within any system. In this case, the system is the stock market. Traders may be able to hedge against certain risks, but they cannot hedge against systemic risk. Consequently, participation in the markets involves tacit acceptance of its systemic risk.

Systemic risk can, in extremes, involve stock market crises with far-reaching consequences. A few of the most sobering examples are the Wall Street Crash in 1929, Black Monday in 1987, the Asian Financial Crisis in 1997 and the Credit Crisis of 2008. During such crises, all prices are likely to suffer.

Traders often refer to the benefits of the system with the oft-repeated adage “A rising tide floats all boats.” Incoming tides certainly lift the entire stock market. Yet the self-same tide can also retreat and can leave the entire stock market marooned. It is when the latter happens that the ability to hedge is a useful tool to try and counteract the risk.