Key Takeaways
- The majority of investors with a mature portfolio seek a mix of alpha and beta.
- Private-market alternative investments (like real estate) generally bear a lower degree of systematic risk.
- REITs tend to offer a higher degree of correlation to public markets and less exposure to alpha than private real estate investments.
What Is Systematic Risk?
Systematic risk is a concept that every self-directed investor should be aware of. This type of risk refers to the investment risk present in the entire market, as a function of macroeconomic, geopolitical, or policy factors. In other words, risk that is always present in public markets, but not specific to individual assets. Systematic risk may be used interchangeably with “market risk,” “undiversifiable risk,” or “volatility.”
Systematic risk, idiosyncratic risk, beta, and alpha are all important concepts in understanding strategic asset allocation and the mechanics of portfolio diversification.
Definition of Systematic Risk
Systematic Risk: The investment risk inherent in the entire market or financial system, affecting assets in nearly every industry. That is, the opposite of “idiosyncratic risk” — risk that is inherent in a specific asset, position, or investment business plan.
Unpredictability is a key feature of systematic risk. As we have noted elsewhere, “timing the market” is next to impossible, and not a viable long-term strategy for individual investors. Diversification and sound asset allocation strategy are key to mitigating your exposure to systematic risk.
In 2025 and in the years to come, we can anticipate that systematic risk may emerge as a result of one or more of the following factors:
- Geopolitical tensions: Global tensions, including U.S.-China trade issues and conflicts like Russia-Ukraine, could disrupt trade and destabilize markets, creating widespread economic risk.
- Top-heaviness in public equities: The S&P 500’s reliance on a few mega-cap tech stocks for growth makes the market vulnerable to volatility if these companies face downturns, as they disproportionately influence overall market performance.
- A shifting interest rate environment: Changing interest rates impact borrowing costs and asset valuations, as demonstrated by the Fed’s rate cut in September.
- Novel pandemics, environmental disaster, or other black swan events: These events can disrupt global economies in unpredictable ways, creating sudden, significant market volatility. For example, the impacts of Helene and Milton.
While these threats stand as potential systematic risk, no one can predict the future, and prudent investors can focus on diversifying their portfolios and staying informed to better navigate an evolving market landscape.
Investing in Alpha vs Beta
“Beta” is a coefficient that reflects the volatility, or systematic risk, of an individual asset — such as a publicly-traded tech stock. A value of 1.0 indicates that the asset is strongly correlated with the overall market, and can be expected to exhibit volatility very similar to the stock market over time.
A beta value of greater than 1.0 indicates that the asset is more volatile than the market as a whole. For instance, adding a stock to your portfolio with a beta of 1.3 will theoretically increase both the risk and potential return of the portfolio. Put differently, the higher the beta value, the greater an asset’s sensitivity to systematic risk.
A beta value of less than 1.0 implies that the security is less volatile than the market as a whole, and adding the asset to a portfolio will reduce overall exposure to risk. Investing literature often refers to “investing in beta” or “buying the market” as a good way for less experienced (or time-constrained) investors to tap into broad-based growth in the economy and avoid undue volatility. As such, index funds — and a growing crop of robo-advisors who aggregate ETFs — seek to offer an aggregate beta of close to 1.0. As we have argued, investors are best served by supplementing publicly-traded assets with illiquid, private-market investments like commercial real estate.
The EquityMultiple Team discusses asset classes and associated levels of risk and potential return.
Alpha, conversely, measures the degree to which an asset or investing strategy beats the market. The term is often used interchangeably with “abnormal rate of return,” implying that alpha can only be found via skilled management that achieves returns in excess of benchmarks. Recent data suggests that active managers of portfolios and funds are rarely able to achieve alpha consistently over the long term, prompting many investors – even those with considerable net worth – to instead allocate primarily to index funds through robo-advisors, prioritizing beta in their portfolios.
While alpha and beta are most commonly used in assessing the performance of publicly-traded stocks, these concepts are extensible to real estate investing as well. As we have noted previously, REITs tend to correlate more closely with public equities markets than illiquid, private real estate. Put differently, public REITs tend to exhibit a beta value closer to 1.0. Returns for private, illiquid real estate depend on skill in asset management and discovering value that stems from market inefficiencies: entering into a market or submarket that is undervalued; acquiring a property at below-market value; leveraging superior scale and operational capability to update multi-unit properties and bring rents to market rate; introducing new amenities or technology; or some combination thereof.
Meanwhile, values of private real estate assets tend to be less responsive to market shocks (particularly in certain real estate asset classes, like self-storage or workforce housing). In other words, private-market real estate carries a greater potential for achieving alpha, and entails a lower degree of systematic risk than is generally observed in public asset markets.
Private-Market Alternatives and Systematic Risk
Public markets rebounded in 2023 from one of the worst years on record in 2022. However, public markets may be susceptible to systematic risk for a number of reasons that would only become clear in hindsight. Some of these factors are concisely delineated in a recent Blackstone study.
- Recent stock market success is largely confined to a handful of stocks in one sector
- Price/earning ratios are at elevated levels
- It is possible that the contractionary effects of increased interest rates have not manifested across most of the economy yet. In other words, some form of a recession following the Fed’s campaign of interest rate hikes is still possible.
Unpredictable macroeconomic shocks and global events are also forms of systematic risk. COVID-19 provides one example, with the pandemic immediately impacting the share price of public assets across sectors. While public markets rallied quickly, we don’t know what impact future events could have on supply chains, global trade, economic productivity, or other macro dynamics that impact asset valuations. Valuations of private-market alternatives, such as real estate, are illiquid and typically are not as sensitive to such macro factors. This partly reflects the tangibility and inherent worth of real estate; while a sustained economic downturn will impact average rents and real estate valuations, in the short term people will still need places to live, work, and congregate, regardless of how quickly or significantly public equities markets have plummeted.
While it is not possible to fully diversify against risk of an economic downturn, it is possible to reduce exposure to systematic risk by adding private-market alternative assets to a portfolio comprised of traditional assets like stocks and bonds.
The Bottom Line
The U.S. economy moves cyclically. While market cycles have followed some predictable patterns when examined retroactively, no human (or even machine) has been able to accurately and consistently predict major shifts in public equities markets. Broad exposure to the market — investing in beta — has proven to be a sound strategy in the long run. Exposure to illiquid, private-market alternatives — such as commercial real estate — may help to reduce an investor’s exposure to systematic risk in an era when public markets have exhibited greater volatility.
Heading into 2025, recent rate cuts signal a shift toward stabilizing economic growth, though uncertainties remain about the long-term impacts of prior rapid rate hikes. In this environment, private-market assets with distinct risk/return profiles can offer resilience against systematic risk, especially as investors seek stable returns beyond the public markets.
Systematic risk is an unavoidable aspect of investing, but with the right approach and resources, it can be managed effectively. For accredited investors in CRE, platforms like EquityMultiple offer valuable tools and insights to help navigate these risks and make strategic investment decisions.
By staying informed, diversifying investments, and leveraging professional expertise, investors can position their CRE portfolios to weather market uncertainties and capitalize on long-term growth opportunities.
Update for 2025 (and Beyond) — Systematic Risk and the Next Phase of the Cycle
Finance and investing media referred to COVID-19 as a “black swan event” — a shock to markets that could not have been predicated or adequately priced in as risk. Whether or not an infectious disease outbreak of this magnitude could have been predicted is a matter of some debate, but it undeniably shocked financial markets.
While the impact of the pandemic has made lasting impacts on society, the economic pain has largely resolved. In terms of markets, the pandemic caused a brief, acute recession, from which markets recovered quickly (relatively speaking).
However, the pandemic indirectly created a key ingredient of the major market force that has characterized the period between early-2022 and late 2023: inflation. Stimulus spending, work disruptions, and snarled supply chains contributed to demand and supply-driven inflationary pressures. By late 2022 inflation was dominating headlines and causing pain in the stock market. Following the most acute inflationary period in several decades, the Federal Reserve embarked on the most aggressive contractionary monetary policy since the early 1980’s. This created distress in the medium-sized banking sector and ongoing interest rate risk for a variety of institutions and components of the financial system.
In September 2024, the Fed cut rates by half a basis point, signaling a shift toward stabilizing economic growth while acknowledging the need to ease the burdens of extended high rates. Looking forward to 2025, this cut may pave the way for further rate adjustments, potentially moderating the cost of borrowing and enhancing market liquidity. However, uncertainties remain about whether this loosening of policy will stimulate sustained economic recovery or, alternatively, foster inflationary pressures that would necessitate a return to restrictive measures.
This is all to say that systematic risk is ever-present and unpredictable. With public markets affected by a whole host of potential shocks across the globe, private-market assets may be worth considering.
FAQs on Systematic Risk in CRE Investing
Q: Can systematic risk be completely eliminated in CRE investing?
A: No, systematic risk cannot be completely eliminated as it is inherent to the entire market. However, it can be managed through diversification, staying informed, and adopting a long-term investment horizon.
Q: How does EquityMultiple help investors manage systematic risk?
A: EquityMultiple offers a vetted selection of investment opportunities, educational resources, market analysis, and access to industry expertise, all of which can aid investors in making informed decisions to manage systematic risk.
Q: Is CRE investing suitable for investors with a low-risk tolerance?
A: CRE investing can be suitable for investors with a low-risk tolerance if they focus on stable, income-generating properties and adopt a long-term perspective. However, it’s important for each investor to assess their individual risk tolerance and investment goals.
Q: How important is diversification in managing systematic risk in CRE?
A: Diversification is a key strategy in managing systematic risk. By spreading investments across different geographies, property types, and investment structures, investors can reduce the impact of market-wide fluctuations on their portfolio.
Q: Should investors avoid CRE during periods of high systematic risk?
A: Not necessarily. While high systematic risk periods require caution, they can also present opportunities for investors who have done their due diligence and have a clear understanding of their investment strategy. It’s important to assess each opportunity on its own merits and in the context of one’s investment goals.
1 Source: CNN Business, December 31, 2018: https://www.cnn.com/2018/12/31/investing/dow-stock-market-today/index.html