INVESTMENT RISK

In the financial world, a fundamental risk is volatility. Volatility is the size and frequency of changes in a stock, bond, or other security—or in a stock, bond or other securities market as a whole.

How far and how fast does a stock or the stock market rise or fall in a given period? The answer to this question describes the degree of volatility involved.

For instance, say you are considering purchasing one of two stocks issued by similar health-related companies. Over the past 10 years, Stock A has annually posted a stable return, always in the 8 percent to 10 percent range. Stock B, on the other hand, has posted both big annual gains and losses; one year it was down 20 percent from the previous year. Yet at the end of the 10-year period, Stock B posted an average annual gain of 14 percent per year. Clearly, Stock B is more volatile than Stock A.

In the above example, Stock A and Stock B performed differently due to internal performance issues—maybe Company B experienced a high rate of executive turnover or experimented more heavily with new product introductions. But sometimes a crucial factor in a stock's performance is not an internal issue, but a marketplace issue. For instance, most stocks might be either boosted (in the case of a bull market) or dragged down (in the case of a bear market) by prevailing marketplace trends.

That is where market risk comes in.

Market risk is the fluctuation of investment prices due to investor demand (or lack of demand) for securities in the market as a whole.

Some market risk refers to the portion of a stock or other security's risk that is shared by all similar securities. If the bond market is generally down, it is demonstrating market risk. Market risk affects all classes of securities. However, market risk may also affect securities individually. If a company is perceived as a good investment, its price will rise as investor demand increases, even if the market in general is down.

Next up: How to judge the level of risk in investments.