By Jeffrey Meenes, CFP® (Published Date April 27,2023)
Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. Market risk and specific risk (unsystematic) make up the two major categories of investment risk. Market risk, also called "systematic risk," cannot be eliminated through diversification, though it can be hedged in other ways. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. Systematic, or market risk, tends to influence the entire market at the same time.
This can be contrasted with unsystematic risk, which is unique to a specific company or industry. Also known as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," in the context of an investment portfolio, unsystematic risk can be reduced through diversification.
Market risk exists because of price changes. The standard deviation of changes in the prices of stocks, currencies, or commodities is referred to as price volatility. Volatility is rated in annualized terms and may be expressed as an absolute number, such as $10, or a percentage of the initial value, such as 10%.
Many professionals receive compensation in the form of company holdings or participate in Employee Stock Purchase Plans (ESPP), which can expose them to individual security risk and employment risk. Individual security risk arises when professionals become overweighed in a single security due to a lack of portfolio monitoring, which can subject them to dangerous investment risk. Holding 5% or more of one's portfolio in a single security, such as stocks, restricted stock options, or bonds, is considered a concentrated position and should be reflected in assumptions when creating a financial plan.
Moreover, if a concentrated position is in the company where the professional works, employment risk becomes a concern. If the company experiences difficulties or goes bankrupt, the individual could lose not only the equity previously held in those investments but also their source of income. This situation could lead to substantial losses of both a job and assets due to factors beyond an individual's control.
To mitigate these risks, it is crucial for professionals to diversify their investment portfolio, reducing exposure to individual security and employment risks. Diversification can be achieved by investing in a variety of assets such as stocks, bonds, and real estate or investing in index funds or exchange-traded funds (ETFs) that provide exposure to a broad range of investments. By diversifying their portfolio, professionals can better protect themselves against potential losses and achieve their financial goals.
This content is developed from sources believed to be providing accurate information, and provided by Meenes Wealth Partners. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.