A:

Market risk and specific risk are two different forms of risk that affect assets. All investment assets can be separated by two categories: systematic risk and unsystematic risk. Market risk, or systematic risk, affects a large number of asset classes, whereas specific risk, or unsystematic risk, only affects an industry or particular company.

Systematic risk is the risk of losing investments due to factors, such as political risk and macroeconomic risk, that affect the performance of the overall market. Market risk is also known as volatility and can be measured using beta. Beta is a measure of an investment's systematic risk relative to the overall market.

Market risk cannot be mitigated through portfolio diversification. However, an investor can hedge against systematic risk. A hedge is an offsetting investment used to reduce the risk in an asset. For example, suppose an investor fears a global recession affecting the economy over the next six months due to weakness in gross domestic product growth. The investor is long multiple stocks and can mitigate some of the market risk by buying put options in the market.

Specific risk, or diversifiable risk, is the risk of losing an investment due to company or industry-specific hazard. Unlike systematic risk, an investor can only mitigate against unsystematic risk through diversification. An investor uses diversification to manage risk by investing in a variety of assets. He can use the beta of each stock to create a diversified portfolio.

For example, suppose an investor has a portfolio of oil stocks with a beta of 2. Since the market's beta is always 1, the portfolio is theoretically 100% more volatile than the market. Therefore, if the market has a 1% move up or down, the portfolio will move up or down 2%. There is risk associated with the whole sector due to the increase in supply of oil in the Middle East, which has caused oil to fall in price over the past few months. If the trend continues, the portfolio will experience a significant drop in value. However, the investor can diversify this risk since it is industry-specific.

The investor can use diversification and allocate his fund into different sectors that are negatively correlated with the oil sector to mitigate the risk. For example, the airlines and casino gaming sectors are good assets to invest in for a portfolio that is highly exposed to the oil sector. Generally, as the value of the oil sector falls, the values of the airlines and casino gaming sectors rise, and vice versa. Since airline and casino gaming stocks are negatively correlated and have negative betas in relation to the oil sector, the investor reduces the risks that affect his portfolio of oil stocks.

RELATED FAQS
  1. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
  2. What are some common measures of risk used in risk management?

    Learn about common risk measures used in risk management and how to use common risk management techniques to assess the risk ... Read Answer >>
  3. Systemic versus systematic risk: What's the difference?

    Systemic risk generally refers to an event that can trigger a collapse in a certain industry or economy, whereas systematic ... Read Answer >>
  4. Financial Risk vs Business Risk

    Understand the key differences between a company's financial risk and its business risk – along with some of the factors ... Read Answer >>
  5. How does beta measure a stock's market risk?

    Learn how beta is used to measure risk versus the stock market, and understand how it is calculated and used in the capital ... Read Answer >>
Related Articles
  1. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
  2. Investing

    The Dangers Of Over-Diversifying Your Portfolio

    If you over-diversify your portfolio, you might not lose much, but you won't gain much either. Find out how to maintain a well-balanced set of investments.
  3. Managing Wealth

    Avoid Future Shock By Protecting Your Portfolio With Futures

    Worried about protecting your portfolio of diversified stocks and assets? Using futures with correct strategies can help.
  4. Financial Advisor

    Active Risk vs. Residual Risk: Differences and Examples

    Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
  5. Investing

    Beta: Know the Risk

    Beta says something about measuring price risk in stocks, but how much does it say about fundamental risk factors too?
  6. Financial Advisor

    Example of Applying Modern Portfolio Theory (MPS)

    Modern Portfolio Theory: brush up on key mathematical framework used in investment portfolio construction.
  7. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  8. Managing Wealth

    One Portfolio For Asset Allocation

    If you treat all of your investments as a single portfolio, you will be better able to maximize returns.
  9. Investing

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  10. Small Business

    Diversification and Startup Investing

    Startup investments, considered a subset of venture capital, are subject to the same principles of diversification and portfolio management as publicly traded companies.
RELATED TERMS
  1. Systematic Risk

    Systematic risk, also known as market risk, is risk inherent ...
  2. Unsystematic Risk

    Unsystematic risk is unique to a specific company or industry ...
  3. Price Risk

    Price risk is the risk of a decline in the value of a security ...
  4. Operational Risk

    Operational risk summarizes the risks a company undertakes when ...
  5. Idiosyncratic Risk

    Idiosyncratic risk refers to factors that impact a particular ...
  6. Business Risk

    Business risk is the possibility a company will have lower than ...
Trading Center