The Finance Professor: Understanding Risk

Market risk: This form of risk represents your exposure to the overall market. For example, if the S&P 500 (SPX Quote) were to go up and your portfolio would also rise, then you have market risk to that particular index .

What gives rise to market risk is something that we call beta . Beta represents a stock or portfolio's correlation to an index. (For those readers more statistically astute, beta is the correlation coefficient derived when performing a regression between a stock/portfolio and an index.)

In other words, for every 1% movement in the index, your stock or portfolio would rise X%. Beta is typically displayed as a unitized number. Thus, a beta of 1.5 means that for every 1% move in the index, your investments would increase 1.5 times 1% or 1.5%. While I used the S&P 500 as an example of the market portfolio, your individual portfolio might more closely track the Dow Jones Industrial Average (DJIA Quote), Nasdaq 100 (NDX Quote) or Nikkei 225 (see average ).

Systemic risk: This risk is associated with a complete breakdown of an economy, market or segment thereof. Examples of systemic risk include the Great Depression in 1929, the Arab oil embargo in the 1970s, the Latin American debt crisis of the mid-1990s, the Russian financial crisis in the late 1990s, and the Asian contagion in the late 1990s.

A systemic risk is the most formidable danger posed to an investor because of the difficulty or inability to predict its occurrence and manage its outcome.

Interest rate risk: Exposure to all or part of the term structure or nature of interest rates will create financial danger to an investor. There are two aspects to these risks. First is the term structure. Interest rates are quoted based on time to maturity .

Yield will vary by maturities, thus creating what we call the yield curve . The second facet of interest rates is the fixed and floating aspect of those rates. Fixed-rate investments will yield the same rate for the entire duration of the investment. Floating or variable interest rates will fluctuate over time.

Interest rate risk will affect both lenders (bond buyers or mortgages ) and borrowers (such as mortgagers). Finally, while interest rate risk has a direct impact on fixed-income investors , there is only a secondary effect on stock investors ("Getting Started With Stocks").