Investing is always a balance between risk and reward. The more risk there is of losing your money, the greater the reward will be if the investment pays off. It can feel a bit like gambling, but with investing there's a big difference: You're the one who decides the odds. You do that by calculating how risky each individual investment is, but also by considering the market as a whole. That big picture overview is usually referred to as market risk.
What Is Market Risk?
Business people are fond of saying, "a rising tide floats every boat," meaning that when things are going well everybody benefits. Unfortunately, the reverse is also true, so even the best-run company can take a beating – and devalue your investment – if it gets caught up in a broader downturn. That's market risk: the chance that a broad change of conditions will deflate a whole sector of the economy, the national economy itself or even an entire international region. No matter how carefully you've chosen and diversified your individual investments, this kind of risk, also known as systematic risk, can hit you where it hurts.
Types of Market Risk
Markets hate unpredictability, so most forms of market risk are related to the possibility of widespread, unforeseeable variability. This is usually referred to as volatility, and it can come in a number of forms. Interest rate risk is the possibility that a dramatic change in interest rates will affect profits. A drop can hurt companies that deal in bonds and other fixed-rate securities, for example, while a rise can hurt companies that borrow money or float bonds for operating capital.
Equity risk is the volatility that's built into overall stock markets, while commodity risk is the same principle applied to the market for commodities, such as crude oil. Currency risk applies to companies or financial sectors that operate in multiple countries and can be hurt by sudden swings in exchange rates. Country risk reflects political volatility, the chance that a change in government or government policy – or worse, a war or significant natural disaster – could drag down all markets within that country.
What Is a Market Risk Analyst?
Unsurprisingly, the investment community has a strong interest in finding ways to predict and manage market risk. That's the job of market risk analysts, people who spend their days researching factors such as public policy or interest rate cycles in an effort to understand and predict how those factors might affect a company's operations or investments. Working in market analysis can be just one phase in a broader financial career, part of becoming a well-rounded manager or executive, but it can also be a full career path in itself. The American Academy of Financial Management offers a Chartered Market Analyst certification for those who choose to make it their full-time specialty.
What Are Market Risk Models?
Risk analysts model market risks in various ways to help make sense of raw data. One widespread model employs the value-at-risk method, or VaR. This method subjects a market's major variables to some serious math in an effort to determine what the worst-case scenario might be and how likely that is to happen. Another common model used by analysts is the capital asset pricing model, or CAPM, which tries to define the relationship between market risk and the return an investment potentially offers. It's still the same question of risk vs. reward, but by reducing that relationship to numbers that can be compared against each other.
These models follow well-established principles, but investment firms and individual analysts fine-tune them constantly in search of better results, in much the same way meteorologists continuously refine their weather prediction models. Ironically, these risk models themselves represent yet one more form of market risk. If your model is flawed, investments you make based on that model may expose you to more risk than you realize.