What is market risk?

The market risk refers to any investment risk that cannot be eliminated through diversification. Market risk, also known as systemic risk, affects all securities. Market risk cannot be overcome by diversifying the portfolio. Company-specific risks can be eliminated by owning a variety of different securities. Investors should consider the overall risks of their entire portfolio.

Definition and Examples of Market Risk

When investing in securities such as stocks and bonds, you are assuming risks. Generally, investment risk is considered the uncertainty surrounding your return. In other words, the actual return you receive can differ from the expected return.

There are many sources of risk that bring this uncertainty, and they can be divided into two main types:

Market Risk

Also known as systemic or economic risk, or non-diversifiable risk. Market risk affects all securities in the market and cannot be eliminated through diversification.

Company-Specific Risk

This type of risk does not affect all securities and can be reduced through diversification. Company-specific risks can be completely eliminated by owning a variety of different securities.

Types of Market Risk

Market risk is also referred to as systemic risk because it is not unique to a particular investment. These risks affect the entire market or a class of investments. Here are some examples of systemic risks:

Interest Rate Risk

Interest rates change over time due to the business cycle and changes in monetary policy. When interest rates change, it usually affects the prices of securities. When interest rates rise, bond prices and sometimes stock prices fall, and when interest rates decrease, stock and bond prices rise.

Reinvestment Risk

Some investments provide the investor with periodic cash flow or income. Some stocks provide cash flow in the form of dividends, and bondholders receive regular interest payments. An investor may choose to spend these cash payments or reinvest them.

An investor who chooses to reinvest the cash payments may not achieve the same rate of return as the original investment. For example, if an investor holds a bond that pays a 6% coupon, but interest rates have fallen since the bond was issued, the investor may only be able to buy a similar bond with a 5% yield.

Inflation Risk

Inflation risk, or purchasing power risk, refers to the possibility that inflation will erode the real purchasing power of the investment and the cash flows it provides. Because of purchasing power risk, investors hope to achieve a rate of return that exceeds inflation over time.

Currency Risk

Foreign investments expose the investor to currency risk, or the risk of changes in exchange rates between currencies in different countries. Currency risk refers to the uncertainty in the exchange rate when an investor eventually converts an investment in another country back to their own currency.

Political Risk

Political risk, also known as sovereignty risk, refers to the risk that the legal environment of a country could negatively affect investments in a foreign country. For example, if you invest in foreign government bonds, investors face the risk that the government will default. There is also the threat that a foreign government may seize the private companies you have invested in.

Note: Market risk cannot be eliminated through diversification. It is ideal for investors to manage market risk by choosing an asset allocation. For example, currency risk can be reduced by decreasing the percentage of the portfolio composed of foreign investments.

Alternatives

Market Risk

In addition to market risk, there are also unsystematic risks that affect only a specific company. Since these risks are relevant only to an individual company, they can be reduced through diversification. In fact, you can completely eliminate unsystematic risk by holding a large portfolio of different financial securities.

Business Risk

Business risk, also known as operational risk, is any risk arising from natural changes in business operations that can reduce the company’s profits.

Financial Risk

Financial risk is the risk faced by a company due to its reliance on funding sources and financing sources, which are debt and the use of leverage. This exposes the company to the risk of having to repay principal and interest.

Market Risk vs. Specific Company Risk

Investors need to consider investment risks in terms of their overall portfolio. Investing involves market risks and specific company risks.

Note: When an investor holds a properly diversified portfolio, their exposure will be limited only to market risk. Specific company risks can be completely eliminated through diversification by holding securities from multiple sources.

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Sources:

Herbert B. Mayo. “Investments: An Introduction,” Pages 137-139. Cengage Learning, 2020. Accessed July 26, 2021.

Source: https://www.thebalancemoney.com/what-is-market-risk-5194188