Market Beat: Types of risk in the stock market
December 21, 2011
TRUCKEE, Calif. andamp;#8212;Systematic Risk: Systematic risk is defined as a risk to an entire financial system. If the entire system goes through a shock or collapse even broad based index funds will suffer and the melt down can go through multiple asset classes simultaneously. Diversification can help and hedging can definitely help control systematic risk. Owning long put option contracts or inverse funds can be one of the best ways to hedge against systematic risk.Non-systematic Risk, or Company Specific Risk: Non-systematic risk also known as company specific risk can be diversified away. It is the risk of one company failing due to multiple reasons including product failure, lawsuits, fraud, etc. Wall Streetandamp;#8217;s history is full of stories of companies that were substantial at one time failing completely. WorldCom was the second largest long distance carrier in the US behind only ATandamp;T; Enron was one of the worldandamp;#8217;s leading energy companies. Both stocks imploded and became worthless. Company specific risk can be reduced by using broad based index funds.Contagion Risk: Contagion risk is similar to systematic risk but is defined as a scenario where one financial event leads to another which eventually leads to a meltdown. The US subprime crisis of 2008 as first appeared to be limited to the US housing market, but eventually spread to lending liquidity, bank reserve requirements and went overseas to Europe and Asia. Stocks plunged and investors fled to safe investments like US Treasuries. Contagion can be diversified to some extent by holding treasuries and other andamp;#8220;safe havens investmentsandamp;#8221; in your portfolio and by hedging.Inflation Risk: Inflation risk is one of the worst types of risk an investor can face. Though not as shocking to a portfolio as a market crash, the steady erosion of your purchasing power over time can have devastating long term effects. The way to combat inflation risk is to invest in securities whose return exceeds the rate of inflation, which means investing in equities. Adding commodities to a portfolio can be a good inflation risk hedge because many commodities can keep pace with inflation. An inflationary period combined with a market crash can be especially devastating to a portfolio. The value of an equity portfolio can decline dramatically at a time when an investor needs extra funds to keep up with inflation.Kenneth Roberts is a Truckee based Registered Investment Advisor. He has been a Truckee resident for 24 years. Ken has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm, and is currently a portfolio manager for Fusion Asset Management who specializes in target retirement and income producing portfolios. His has extensive experience using options as a portfolio management tool for both risk reduction and income production. Information on his money management service can be found at http://www.fusiontargetretirement.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.