Risk: Market And Specific

By Arkaitz Arteaga

There is always risk in any stock traded, no matter how
predictable a stock can be or how much research has been done on
the stock. Risk on a stock is divided into two parts. There is
market risk and specific risk. These two risks are very
different. The differences between the two will be explained.

Market risk is risk that can not be diversified away. Market
risk can also be referred to as systematic risk. This form of
risk refers to matters that are out of the investors control.
For example, changes in a stock price due to changes in the
stock market. All forms of securities have market risk. This
includes, bonds and stocks. Market risk is a mixture of the
market, inflation rates and interest rates. For example, if the
market suddenly increases, most stocks increase in value as
well. However, if the market suddenly decreases, so does the
value of the stock. These three factors can not be avoided by
any investor. It effects everyone participating in the stock
market. Thus, market risk can in no way be diversified away.

Specific risk on the other hand can be diversified away.
Specific risk can also be referred to as unsystematic risk.
Specific risks are risks that are unique to a stock. It includes
business and financial risk related to the stock. As well as
that, liquidity risk. The amount of specific risk can be reduced
through diversification. An example of specific risk is, say
news about a specific stock, where there is a strike by the
employees in the company where there are shares you hold.

There is a system that is able to differentiate from market and
specific risk effecting any particular stock. This system is
called the fama-French tree factor model. It differentiates
between the two risks by using three factors. Firstly there is
the book to market ratio. Secondly there is the magnitude of the
firm. Lastly there is the market portfolios return.

Firstly, the ratio referred to as the book to market ratio
simply is the estimate of the companies worth divided by the
magnitude of the firm. Secondly, the magnitude of the firm is
brought about by the shares price times the added number of
shares the firm has in the market. Thirdly, an index like S&P
500 is where the return on the market portfolio is retrieved
from.

Under the fama-French three factor model, market risk is
classified as the book to market ratio and the magnitude of the
firm. This means, that for market risk, a higher amount of
returns is expected. This is because market risk is out of the
control of the investors and they are unable to diversify it,
thus higher amounts of returns are expected. Specific risk is
everything else. This form of risk can be diversified by
investing not only in one stock but in many different company
stocks.

This article has discussed the differences between market and
specific risk. The fama-French three factor model has been
explained and the ways in which it differentiates between market
and specific risk.

About the Author: Arkaitz Arteaga - http://www.marketstock.net
For more information about Stock Market visit
http://www.marketstock.net/category/stockmarket

Source: http://www.isnare.com