Investing in stocks and other securities means accepting a certain amount of exposure to market risk. In simple terms, market risk means there’s a possibility that your investments could lose money. There are different factors that can influence how stock prices move and what that means for your portfolio. Understanding how to measure market risk can help you to develop a strategy for managing its impact on your investments.
For help developing your own strategies to manage market risk, consider working with a financial advisor.
What Is Market Risk?
Market risk is the risk that investments will lose value due to changes in the overall temperature of the market. That type of risk is also referred to as systematic risk since it’s built into the market system as a whole and is not specific to any one industry or sector.
There’s no way to eliminate market risk, as it can be driven by a number of factors that are outside the scope of an investor’s control. In other words, you can’t diversify your way around it with asset allocation alone. There are several subcategories of market risk that can affect investors in different ways.
Interest rate risk. Fluctuating interest rates can increase volatility in the markets and directly impact securities prices. Bond investors may be particularly impacted, as bond prices and interest rates have an inverse relationship.
Currency risk. Currency risk is the risk of losing value when exchanging one currency for another. If you hold investments in a foreign currency and the value of that currency drops, then your investment is worth less.
Commodity risk. Commodities are the raw materials from which other products are derived. When commodities are experiencing price volatility, that can have a ripple effect throughout the broader market.
Equity risk. Equities or stocks have inherent risk because their prices aren’t fixed. There are several factors that can cause price movements in the equity markets, including geopolitical events, the introduction of new government regulations or a public health crisis.
What Is the Best Measure of Market Risk?
Value at risk or VAR is the most commonly used statistical method for measuring market risk. The VAR method is used to calculate the probability of two things:
VAR can be useful for measuring market risk for a variety of investments, including stocks and bonds. There are different ways to calculate VAR, starting with the historical method. In that instance, you’d simply take the historical returns of an investment or a stock market index and order them from lowest to highest. By looking at the highs and lows and where they’re concentrated, you can make an educated guess about where you expect losses to max out.
A second method for calculating VAR uses expected returns and standard deviation to identify a stock’s best and worst performance periods. Similar to the first method, you can use this to make a projection about how you expect a stock to perform going forward.
You can also use something called a Monte Carlo simulation to calculate VAR in order to measure market risk. This strategy uses hypothetical scenarios to predict stock price movements and future returns. Running multiple simulations can give you a loss range to work with for estimating potential losses.
While VAR is often used to measure market risk, it does have some flaws. Although it may be easy to apply one of these calculation methods to a single stock, things can get more complicated when you’re looking at a larger group of assets. It’s also worth noting that the three calculation methods may not produce identical results, which can make it more difficult to gauge market risk.
What Is Market Risk Premium?
Market risk premium represents the difference between a stock or stock market index’s expected rate of return and the risk-free rate of return. A risk-free rate means an investment’s expected return when no risk is involved. You can use market risk premium to estimate market risk.
When you calculate market risk premium, you’re trying to figure out what will happen to a stock’s price if volatility increases. The market risk premium can tell you whether an investment’s projected return is justified by the increased risk involved.
How Do You Manage Market Risk in Investments?
While diversification can be an effective way to manage other types of risk, it’s not as effective for dealing with market risk. There are, however, some things you can do to mitigate the various subcategories of market risk.
For example, if you have bonds in your portfolio then it’s important to pay attention to what’s happening with interest rates. Rate cuts can send bond prices up, while rate hikes can push them down. If you’re in a rising rate environment, then shorter-term bonds could be the better option for managing the risk associated with changing bond prices.
If you’re investing in foreign markets, you can manage currency risk by being careful with asset allocation and studying the currency profiles of those markets. Maintaining a mix of investments that are backed by strong currencies can be another strategy for hedging against market risk.
Looking at the overall condition of the market can help you fine-tune your asset allocation when volatility increases. For example, if you believe the economy is on the verge of slipping into a recession you may choose to move money out of the consumer discretionary sector and invest more heavily in defensive stocks. Utilities and consumer staples, for example, can provide reliable returns in the early stages of a recession, since people still need to spend money on those things day to day.
Dollar-cost averaging isn’t necessarily a risk management tool, but it could help to smooth out returns through changing market cycles. A dollar-cost averaging strategy simply means that you continue to invest the same amount of money on a regular schedule, riding out market ups and downs over time. That’s different from value averaging, which has you investing more or less money depending on how your portfolio is performing at any given time.
One final method for managing market risk is to simply avoid risk altogether. Rather than investing in stocks, bonds or other securities, you might choose to keep your money in certificates of deposit (CDS), money market accounts or savings accounts. While those options can offer security, with virtually zero risk of losing money, returns may fall far short of what you could realize in the market.
The Bottom Line
Market risk is unavoidable if you hold stocks, bonds, mutual funds or other securities in your portfolio. Different factors shape the face of the markets daily, which may bode well – or ill – for investors. The good news is that while you can’t bypass market risk entirely, you can take steps to manage its impact on your investments.
Consider talking to your financial advisor about the best ways to manage market risk when building wealth. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Taking an online risk assessment questionnaire can help you to establish a baseline for your personal risk tolerance. But it’s important to remember that these questionnaires may be limited, in terms of the scope of questions asked. Your risk tolerance may be at one level but your risk capacity, or the amount of risk you need to take to achieve your goals, may be at another. Failing to close the gap could cause you to fall short of your goals, which is another good reason to consult a financial advisor when establishing a risk management strategy.
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