Quick Answer
Market risk, also called systematic or non-diversifiable risk, is the chance the overall market declines and drags down most securities. Recessions and interest rate changes are common causes. Beta measures a security's sensitivity to market moves. Diversification cannot reduce market risk; only hedging and asset allocation can.
All the risks covered so far can affect individual securities or specific investment types. Market risk is different: it affects everything.
What Is Market Risk?
- Market risk (also called systematic risk or non-diversifiable risk) is the risk that the overall market declines, dragging down most securities regardless of their individual merit
- Caused by broad economic, political, or social factors that affect all securities simultaneously
- Cannot be eliminated through diversification (even a portfolio holding 1,000 different stocks is exposed to market risk)
- Variable annuities and variable life insurance carry market risk too: the owner's sub-accounts invest in stocks and bonds, and the owner, not the insurer, bears the loss when those markets fall
Exam Tip: Gotchas
"Systematic" and "market risk" and "non-diversifiable risk" all refer to the same thing. The exam likes to ask for the synonym you did not expect.
Examples of Systematic Risk Events
- Recessions
- Wars and geopolitical conflicts
- Pandemics
- Interest rate changes by the Federal Reserve
- Inflation spikes
- Major policy changes (tax law, trade policy)
Exam Tip: Gotchas
Interest rate changes from the Federal Reserve are a systematic (market) risk, not an issuer-specific risk. They affect bond prices across the board, not just one company.
Beta: Measuring Market Risk
- Beta measures a security's sensitivity to market movements
- A benchmark market index (like the S&P 500) has a beta of 1.0
| Beta Value | Meaning | Example |
|---|---|---|
| Beta = 1.0 | Moves with the market | S&P 500 index fund |
| Beta > 1.0 | Tends to amplify market moves | Technology stocks (beta 1.3 means the stock tends to move about 30% more than the market) |
| Beta < 1.0 | Tends to dampen market moves | Utility stocks (beta 0.6 means the stock tends to move about 40% less than the market) |
| Beta = 0 | No correlation to the market | Certain alternative investments |
| Negative beta | Tends to move opposite to the selected market benchmark | An investment that tends to rise when the benchmark falls |
Think of it this way: Beta tells you how strongly a stock tends to react to moves in the overall market. A beta of 1.5 means if the market drops 10%, that stock tends to drop about 15%. A beta of 0.5 means it would only drop about 5%. Higher beta means more amplified swings in both directions.
Exam Tip: Gotchas
The market benchmark has a beta of 1.0, not 0. A beta > 1 means the security tends to move more than the market; beta < 1 means it tends to move less. Beta captures market-related volatility, not total volatility. Beta of 0 means no correlation.
Why Diversification Cannot Help
- Systematic risk affects the entire market. There is no "safe" corner to hide in during a broad downturn
- In major downturns, stocks, real estate, and corporate bonds can all fall together
- Hedging with index put options can offset stock-market exposure. Asset allocation can also reduce that exposure by shifting part of a portfolio into other asset classes.
Exam Tip: Gotchas
- Systematic risk CANNOT be diversified away. Diversification only eliminates non-systematic risk. If a question asks what risk remains in a fully diversified portfolio, the answer is systematic/market risk.
Systematic risk affects everything. But there is another category of risk that can be managed, and even eliminated: non-systematic risk.
What Should You Check on Exam Day?
- Can you explain why market risk cannot be eliminated through diversification?
- Do you know the three terms that all mean the same thing as market risk?
- Can you state what a beta of 1.0 versus greater than 1.0 means?
- Do you know which two tools can reduce systematic risk?