Managing Stock Market Risk
Stock market risk is subject to one of the guiding principles of finance: risk versus return. What it says is that a trade-off exists between expected investment return and investment risk: safer investments will typically offer lower returns, while higher returns require the investor to assume more uncertainty. The risk for the stock market investor is the uncertainty associated with the return they will get on any particular stock investment. While uncertainty will always be a factor in stock market investing, the savvy investor will take steps to manage this.
The risk associated with stock market investing is divided into two categories:
Managing Unsystematic Risk
Unsystematic risk is the uncertainty associated with unforeseen events that impact a single company (e.g. introduction of new competitive or price pressures) or a small group of companies (e.g. an industry workers strike).
Unsystematic risk is minimized by developing a diverse stock portfolio and through thorough fundamental analysis to assess the financial strength of the company, its management team, and the industry in which it competes.
Managing Systematic Risk
Systematic risk is associated with events that affect the entire economy and the stock market as a whole. Increased interest rates or the development of international political turmoil are associated with this type of uncertainty. A diverse stock portfolio will not minimize systematic risk.
Stock Beta and Systematic Risk
Beta values are used to measure the systematic risk of a stock, measuring how the price of that stock moves compared to the overall market, specifically, the S&P 500 index. While the S&P 500 index carries a beta of 1, a stock with exactly the same price movement would also carry a beta of 1. A stock with a beta greater than 1 demonstrates greater volatility than the index and is viewed as more risky (and possibly offer greater return). Technology stocks and small caps often have betas greater than 1 while a blue chip or utility stock would probably have a beta less than 1.
While stock market investors should be prepared to take on a level of risk associated with the level of return they hope to achieve, they can effectively manage this uncertainty through the research process and ongoing portfolio management.
More about managing stock market risk
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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