Types of Risk

Market risk is the day-to-day fluctuations in a stock's price. Market risk relates to the volatility of the market price of assets. It involves exposure to movements in the level of financial variables, such as stock prices, interest rates, exchange rates or commodity prices. It also includes the exposure of options to movements in the underlying asset price. Market risk also involves exposure to other unanticipated movements in financial variables or to movements in the actual or implied volatility of asset prices and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament", of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction. Market risk is a risk of security that cannot be reduced through diversification. One example of market risk is that a company, whose stock you own will declare bankruptcy, thus making your stock worthless. One more example of market risk is that the market prices of existing bonds generally fall as interest rates rise because investors are not willing to pay par value to own a bond that pays less interest than other bonds available in the marketplace. So if you wanted to sell your existing bonds, you would probably have to settle for less than you paid to buy them.

Diversifiable risk is simply risk that is specific to a particular security or sector so its impact on a diversified portfolio is limited. Diversifiable risks are those that can have their adverse consequences mitigated simply by having a well-diversified portfolio of risk exposures. An example of a diversifiable risk is the risk that...