Question

whats the diffeent between the market risk and stock specific risk? which of the two risk can be dealt via diversification

Answer 1

There are 2 types of risks that affect the asset prices which are Market Risks and Stock Specific risks.

Market Risk is the risk of loosing money due to macroeconomic conditions (like slowdown of economy,defaltion in the economy etc.) or political conditions (political unstability in any country like Brexit).These risks are also called as Systematic Risks. It affects the overall performance of the market and has a deep impact across all assets categories like bonds, stocks gold,commodities etc. Beta is a measure of systematic risks. It is used in Capital Asset Pricing models and can be calculated using linear regression model.

Stock Specific Risks are the risks associated with a specific company or a sector. The best example is of Pharma sector. USFDA (Regulatory body for Pharmaceuticals in USA) inspects the products and manufacturing facilities of Pharmaceutical companies across the globe. The observations from USFDA will only impact the stock price movement of the respective pharma company. It will not have any direct impact on Auto sector, Banking sector, Oil & Gas sector etc. Stock Specific Risk is also called as Unsystematic Risk.

Only Unsystematic risks or Stock Specific Risks can be diversified and not market risks. An investor can have a portfolio of pharma and Information Technology stocks which are not correlated at all. So any sharp price movement in pharma stocks due to USFDA inspection result will not have any impact on Information Technology business and on its stock.