Various Types of Risk in the Market

                For the purposes of this discussion (and most in Finance), one should think of the term risk as an uncertainty, specifically as downside risk or the risk of loss.  No trader or investor worries about the uncertainty that they may unexpectedly see higher gains in their investments.  So we will ignore the upside for the purposes of this topic.  Risk can be divided into a type by the level of the market that it affects.  We will go over the broad types:

• Firm-Specific Risk: The risk that a particular company will perform poorly, or worse – fail altogether.  For example, company ABC releases their quarterly report and falls short of expected earnings for whatever reasons (increased cost of products/services, decrease in demand for their products/services).
• Sector/Industry Risk: The risk that a particular industry or sector will perform poorly (most/all firms within that sector).  The development of file-sharing impacted the music industry significantly, and had a negative impact on the entire sector – from the writers all the way through retail music stores.
• [National] Market Risk: The risk that an entire market will degenerate (most/all sectors within the market).  A simple example of this, and probably one that most of you will remember, was the .com bubble bursting at the turn of the millennium.  It negatively affected the entire market system here in the US.
• Global Market Risk*:  This is solely in my opinion, but I feel that the world market as a whole has a large enough of a degree of separation from individual [national] markets for a distinction to be made in the terms of risk.  The recent Real Estate bubble proliferated through and pulled down not only our national market here in the US, but had major negative effects on the world market.  It encompassed most of North America and Europe, and it impacted markets everywhere in the world.

Many times, firm specific risk is at the root of the other levels of risk. The housing bubble (2008) began in the financial sector, with mortgage lenders relaxing important standards for lending.   It more than likely started with one firm easing its standards in order to gain more business over competitors.  Competitors soon then followed suit in order to balance the odds.  Had the repercussions of lax standards been realized much sooner, the impacts would not have filtered up through every market in the world.
 

Other events however, can bypass firm and even sector risk.  A severe drought, for example would hurt our economy overall – beginning in the commodities markets (corn, cotton, beef, wheat, other produce) and affect many sectors at once.

What does all this mean? Virtually all risk can be largely reduced. Two common practices for avoiding risk are:

Diversification: Spreading assets across different investment types.  See my blog topic on Diversification Basics.
Hedging: Placing your assets on ‘both sides of the fence’.  See my blog topic on Hedging*Not Yet Posted*

* In general, the term ‘Market Risk’ includes the world market as well.  However; I argue that there should be a distinction between this and the domestic market.