Market risk is any kind of investment risk that is not related directly to the management and performance of an underlying company.
For instance, if a recession were to start and the slowdown punishes all companies, that is an economic market risk. It’s an external event that isn’t related to how a company is managed or positioned against its competitors.
Other market risks include terrorism, global conflict, natural disasters and so forth. Just about any large event that might affect all investors in the same way is a market risk.
Similarly, the cost of inputs — oil, raw materials and so on — might change and affect your investment. This is what’s known as commodity risk.
For instance, a carmaker could find that the cost of steel has risen dramatically. That would drive up the cost of cars and possibly slow sales. But the cost increase would be borne by all carmakers, not just one.
If you invest internationally, there could be a big change in the value of a foreign currency relative to the dollar affecting your investment. That’s currency risk.
A company in Great Britain, for instance, transacts in pounds. If the value of the pound falls against the U.S. dollar, any profits in pounds would be worth fewer dollars, since it takes more pounds to buy those dollars. Repatriating the profits results in a lower return for dollar investors.
Finally, the cost of money due to a changing interest rate is interest rate risk. A quickly rising interest rate could turn a profitable investment sour.
Any investment that’s interest-rate sensitive would be affected, but the simple example is home sales. A rising interest rate means higher mortgage rates, which could lead to fewer homes being sold as buyers shy away.
Market risk is differentiated from risk associated with a specific company.
Some of those risks include bankruptcy, management changes, strategic choices by the company within its market, changing consumer demand and technological changes.
For instance, a company might be profitable on the basis of its dominance of a given sector but then find that newcomers in the space provide the same service at a greatly reduced cost.
If the company fails to innovate quickly enough it might soon be priced out of the market and unable to compete. That could lead to an investor sell-off of the stock.
While drastic, such an outcome was entirely within the responsibility of the management of the company. As such, it is a specific, not market, risk
One way to manage such specific risks is to diversify a portfolio by owning many companies, not just a small number of current market leaders.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.