Systemic risk describes the likelihood that an entire financial market will fail. In most cases, investors need to worry about the value of a certain business or commodity. In the case of systemic risk, the focus is on the entire market around a specific business or commodity. These failures generally happen when one key security begins to fail; the resulting panic will cause a ripple effect and other securities start to drop. This begins a chain reaction that causes an entire market to crash.
The main lynchpin in most systemic risk calculations is the way money is moved between different financial entities. Since it is possible to sell off portions of a public business as well as controlled debt, it is easy to move ‘electronic debt’ from person to person. This debt, and the money paid to offset it, only exists in the basest of senses; in reality, this money and debt is simply shuffled from place to place.
When several important businesses become involved in this manner, the systemic risk rises. If one member of such a collective begins to fail, it will cause the associated businesses to fail as well. Investors will see that one part of the collective is dropping and it will cause them to try and pull money out of the other members, since they realize that there is far less money in the collective than it appears.
The rapid loss of money in the associated companies will result in a devaluing of the group as a whole. Should this happen to a large and important security, the resulting shock to the market may be too much for it to accommodate. Investors, after seeing several important companies begin to fail, will start selling off stocks that are related to them.
For instance, if a manufacturing company fails, then investors may begin to sell shares of companies that supply it with raw materials or components. These companies may supply many healthy companies as well, but their association with the sinking group is enough to cause panic. This will then trigger a sale of the other companies they supply, and so on. The problem quickly begins to spiral out of control until an entire market plummets.
There is no real way to avoid systemic risk; an investor can only deal with it should it happen. Even in very diverse portfolios, the loss of an entire market segment will severely hurt the bottom line. In addition, when one market goes down, ripple effects happen across all other market segments. For instance, if a major group of manufacturers failed, the ripples would certainly be felt in the industrial metals segment of the commodities market.