What is Market Risk?
Market risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets.
How Does Market Risk Work?
Market Risk is also referred to as systematic risk or non-diversifiable risk.
Market risk is comprised of the “unknown unknowns” that occur as a result of everyday life. It is unavoidable in all risky investments. It can also be thought of as the opportunity cost of putting money at risk.
For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of deposit. Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index. If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky equity investment.
Why Does Market Risk Matter?
Every investor faces market risk as a securities market follows economic indicators, recessions and the normal business cycle.
The most basic strategy for minimizing market risk is diversification. A well-diversified portfolio consists of securities from various industries, asset classes and countries with varying degrees of risk. The specific risks will offset each other but some market risk will always remain.
Because of market efficiency, you will not be compensated for the additional risks that arise from failure to diversify your portfolio. This is extremely important for those who may have a large holding of one stock as part of an employer-sponsored incentive plan. Specific risk exposes you to adverse events on a company or industry level in addition to adverse events on a global, economic level.