What Is Market Risk?

A Simple Guide for Beginners

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You can’t be an investor and not know the many types of risks that exist. If you are starting out as an investor, you too might be focused on profits like many others, but when you mature as an investor, you will realize that investing is more or just as much about risk management as it’s about profitability.

Now, if you are thinking about investing in stocks, you will have to learn about market risk. It’s one of those things that you will have to come to terms with if you want to be an investor. Let’s see what it’s all about, the many types of market risks, and how you can manage it. 

What Is Market Risk?

The term defines a risk that inherent to the market you are invest in and cannot be avoided through diversification. It is not specifically associated with the asset you are investing in and thus asset-specific loss management or mitigation techniques don’t work against market risks. 

The reason you cannot avoid market risk through diversification is that it affects every asset in the market at once. The most common types of market risks include the rising or falling of interest rates, natural disasters, political conditions, or terrorism. 

Experts also refer to it as systematic risk, whereas you also have unsystematic risk, which is a term used for company-specific or asset-specific risk. The risk of the company you have invested in going bankrupt would be considered asset-specific risk and you can avoid it through diversification. 

The analogy of boats in an ocean would work best to explain this. The risk of your boat’s motor acting up is specific to your boat and you can take care of it with pre-ride maintenance and checkups. However, a tsunami or sea storm would not be a boat-specific issue and you can’t minimize its risk by fixing the motor of your boat. 

Each Market Has Its Own Risk

It is important to mention here that there are risks that affect all the markets at the same time. However, there are also market-specific risks. A market-specific risk means it will affect all the assets within that market, but not the assets outside of that market.

Take the example of regulation of cryptocurrencies. Whenever there is news of cryptocurrencies being regulated, the entire market starts experience a dip. However, the same factor does not have any impact on the stock market or Forex. 

On the other hand, when it comes to natural disasters, they can affect all the markets at the same time. The recent pandemic is the most accurate example of a natural disaster affecting various financial markets at the same time. 

It is true that some assets or a particular market might not show the effects of a natural disaster or hike in interest rate as much as other markets. However, when price movements take place in all markets at the same time, you have to take it on the chin, adapt, and strategize accordingly. 

Various Types of Market Risks

As if the thought of a risk that affects all the assets at the same time was not enough, you have types of market risks to deal with. That’s what tells you the challenges an investor faces in their lifetime before they become a tycoon. 

Here are the different types of market risks. 

Currency Risk

This type of risk is associated with the fluctuation of currency exchange rates and directly affect companies that operate around the globe. You know that currencies are always going up and down in value against each other. 

If a business’ assets are located in two or many countries, it will be on the receiving end of these fluctuations. In a way, for any business that that goes beyond national borders the currency risk is inevitable. 

Now, you don’t have to think that the currency risk will not affect you since you are just an individual. It will definitely affect you too because it will affect the company whose stocks you have invested in. For this reason, it makes sense to learn how you can mitigate this risk as an investor.

The first thing you want to do to avoid this risk is to choose countries that have stable currencies. Another method to mitigate the risk would be to use hedged funds. These are funds that perform the hedging for you rather than you making the effort for it. 

Diversification can solve a lot of problems for investors and it does so in mitigating the currency risk too. Invest in stocks or indices in multiple regional markets. Invest some in index funds and diversify them across several regions, such as Asia Pacific, Europe, the US, etc. 

Last but not least, you can pick index funds that have already taken care of the currency risk for you, and there is none better than S&P 500. It consists of the best companies in America that are already using a variety of methods to hedge currency risk that arises from their sales and operations beyond American borders. 

Commodity Risk 

When the prices of commodities change in a way that they negatively affect your returns, it is referred to as commodity risk. Such a risk can affect you directly if you have invested in commodities or when you have invested in the stocks of the companies that rely on raw materials. 

You should know that commodities are of many types. You have agricultural commodities that consists of wheat, corn, coffee beans, etc. Moreover, energies like crude oil and gas are also part of the commodities. Last but not least, you have precious metals, such as silver, gold, platinum, and palladium in the commodity section. 

There can be many factors that can affect the prices of commodities. For example, there are only a few countries in the world that produce oil. If any of the major oil producing countries stops or decreases its oil production, the act will directly impact oil prices. 

Russia, the United States, Saudi Arabia, and China are among the largest producers of oil in the world. Any political turmoil in any of those countries can affect oil production, and thus oil prices. Also, weather and climatic conditions impact agricultural commodities.

Interest Rate Risk 

It is quite evident from the name what type of risk it is. When interest rates go up or down, the assets you are holding on to may rise or fall in value too. The more important point to mention here is that the interest rate risk affect bond holders more than it affect other investors. 

So, let’s say you have a bond with a duration of 10 years with 5% fixed interest rate. Now, if interest rates on new bonds go up to 7%, you will see yourself at a loss. Keeping in mind that your bond matures in 10 years, you will continue to bear this loss for many years to come. 

To mitigate this risk, you would often want to invest in bonds with different durations. It is also true that bonds already have a mechanism of compensating you for buying long-term bonds. It’s called maturity risk premium. 

In simple words, if you go with a long-term bond with a fixed interest rate, the rates you get will be relatively higher than a bond of the same price but less duration. 

Signs of Market Risk Turning into a Market Crash

You are going to keep an eye on the macro elements if you want to be successful with stocks investments. However, you also have to know when market risk turns into a market crash. As an investor, you should be well-aware of these signals so you can make strategy to offset the effects of a crash. Let’s take a look at some signs that mean market risk is about to turn into a market crash. 

Continuous Negative News on Media

You know how media reports on market movements. You must be accustomed to listening to terms like ‘record high’ or ‘continuous growth’. However, when these terms turn into ‘down by n percent’ or ‘has declined for the nth session’, you know there is something wrong. 

The problem with such reporting is that it causes fear in people. It might not be anything more than an ordinary decline that would end soon. However, it scares people and causes them to drop the towel and pull out their investments as soon as possible. 

Poor Loan Performance

When you see a continuous decline in the loan performance, you can take it as writing on the wall for investors in the stock market. Whether it’s installment loans, mortgage loans, or credit card loans, if you start seeing a decline in those percentages, you should know something bad is coming. 

Top Stocks Start Falling

It doesn’t matter which stocks you are investing in you must keep an eye on the top stocks of the market. How they are performing on any given day or week can tell you a lot about the market as a whole. 

When the best stocks in the market aren’t performing well, you will see them steady. However, if you see the stocks of Apple, Amazon, Google, etc. start to fall in continuous sessions, you can take it as a telltale sign that a crash is about to come in the stock market. 

Rampant Valuation Bubbles 

You should know what stock market bubbles are to identify them. Bubbles occur when certain stocks start selling at an exponentially high value, which isn’t justified by the performance of the company. In other words, you see great increase in the price of the stock on charts, but your fundamental analysis returns nothing. 

Take the dotcom bubble for example. Toward the end of the 20th century, people started buying stocks of the companies whose domains ended in .com, as they thought this was the next big thing. The big problem in those investments was the unbelievably high valuation of companies that had nothing to show in terms of numbers. 

As expected, the bubble popped and the values of those stocks fell so fast that people couldn’t sell them back and obtain their initial investments. It’s worthwhile to mention here that stocks aren’t the only assets prone to a bubble. The cryptocurrency, indices, and commodities markets can also experience such bubbles. 

How You Can Measure Market Risk

There are many methods to mitigate market risks and make your investments successful. However, it makes more sense to measure market risk before you invest in an asset. Note that you can’t avoid these risks since they are beyond your or any other investor’s control. 

However, you can definitely measure mark risk to secure your investments. VAR remains one of the most common ways to manage market risk because it’s easy to understand even for beginners. 

Value at Risk Method to Measure Market Risk 

As stated, it is quite easy to understand this measure. It turns potential market risk into a quantity that you can easily interpret. The final number you see as a result of VAR can be in the form of a percentage or dollar amount. 

So what does it exactly tell you? It tells you how probable it is for a loss to occur and what that probable loss would be. In simple words, you get to know how much loss you could incur and what the chances are that this loss will occur.

Here are the three elements that make up a VAR results.

  1. Probable loss
  2. Timeframe
  3. Probability of loss

So, let’s say you want to invest in Google stocks (GOOG) and it shows a VAR of 6% at 95% in the next week. Here’s how you’ll read it.

  1. The probable loss will be no more than 6% of the portfolio 
  2. The prediction the probable loss is applicable for a week
  3. There is 95% certainty that this will happen

You can see how easy it is to know the market risk using the Value at Risk method.

Other Risks You Must Tackle as an Investor

In addition to the risks stated above, there are some other types of risks that affect every investor in the world. You have to manage these risks well because ignoring them could be detrimental to your investment career. Let’s take a look at these risks and how you can mitigate them. 

Investing More than You Can Afford

Before you invest, you have to know how much you can or should invest. There are two important rules to keep in mind as a beginner. First, you don’t want to put your entire life’s savings on the line. Second, you cannot invest all that you have allocated for investments at once. 

Let’s say you want to invest in the stock of a new and emerging technology company that you think will disrupt the technological space. You look at your savings account that has $10,000 in it and invest all of that money in that stock. 

You made three big mistakes here. Firstly, you invested everything you had in your savings. Secondly, you invested all of it in the same stock. Thirdly, you invested all of it at once. Now, if the stock of that company tanks because they couldn’t solve the exact problem they created the product for, you’ll lose everything you had. 

Whatever savings you have, make sure you allocate only 15% of it for investments. If you have confidence in the asset that you are about to invest in, you should still cap your investment at 25% of your savings. 

An important factor you should know here is to lock in that investment percentage. You don’t want to spend on your wants and needs, and then try to see how much is left for you to invest. Instead, you should separate your income into three parts i.e. wants, needs, and investment, as soon as you get it. 

Your tolerance level as an investor is also governed by factors like your age, size of your portfolio, your investment strategy, and the width of the time horizon. Let’s see how these 4 factors affect your risk tolerance. 

  1. Age: If you are young, you can work and make money. You don’t have to rely solely on your retirement savings, thus giving you more risk tolerance than an investor aged 60.
  2. Investment Strategy: If your investment strategy is focused on growth, it will require you to take bigger risks than it would if you were investing for capital preservation or income generation.
  3. Size of Portfolio: In simple words, the more your portfolio is worth, the more risk you can take on. Your risk tolerance also depends on how diversified your portfolio is—more diversified means higher risk tolerance.
  4. Time Horizon: The more time you have the more risks you will be able to take. Also, the overall market data shows that in the long-term, markets tend to rise in value, while the opposite is true in the short-term.

Once you understand these aspects of risk tolerance, you can also define your risk tolerance strategy. Yes, you can go conservative, aggressive, or moderate with your risk tolerance. 

Signing up with the Wrong Stock Broker

Take your time before you finally decide to sign up with a stock broker. Here, you can go wrong in two ways, and one of the mistakes is bigger than the other. So, you can either go wrong by picking a broker that doesn’t provide you with the type of investment strategy or assets that you are interested or by picking a deceptive broker that’s after your money. 

For example, when it comes to robo-advisors, they usually use very basic and simple trading strategies. The returns they give you on your investments are quite small. To expect them to give you huge gains on your investments wouldn’t be wise. 

Let’s say you want to go with a human broker who manages your portfolio on your behalf. In that case, you want to be sure about the funds and assets they have available on their asset index. It would do you no good if you found out they don’t offer the asset you are interested in after you sign up. 

Signing up with a deceptive broker is unfortunate and can instill a fear of investing online in your heart. There are certain signs that can help you identify a fraud or deceptive broker as soon as you inspect them closely. Let’s take a look at a few. 

  • They make promises. It doesn’t matter how big or small or realistic the promises sound. The truth is, a broker can never ‘promise’ you anything.
  • They tell you that your investments could make you a millionaire overnight. It’s not just a red flag, it’s a visible landmine. 
  • They are not licensed to provide you with their brokerage services.
  • They never ask you what type of investment goals you have and give you a cookie cutter solution out of their bag of tricks.
  • They commit what is called churning. What it means is that since they charge you a commission on each transaction, they execute many micro transactions. Your earnings might be minimal but they make great commission from those transactions. 
  • Last but not least, they tell you about stocks you’ve never heard of. While they are telling you the names of the companies, you’re scratching your head and thinking what those things are. 

If you witness any of these signs an online broker, make sure you avoid them and look for a stock broker that’s licensed, regulated, and provides you with proper brokerage services. 

Final Thoughts

Market risk is inherent to every market and there is no way to diversify this risk. You can use hedging techniques mitigate the effects of this risk, but it makes more sense to measure the risk and strategize accordingly. They say calm seas don’t make for skillful sailors. In terms of investing, it means you measure these risks and find ways to keep afloat despite their presence. That’s what makes you a true, tested, and successful trader. 

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