Market risk is the chance that an investment will not maintain its value when it is dependent on the many factors that influence the health of the economy and the stock market. Investors must be aware that investing money in a stock or mutual fund is to tie the fate of that money to the fate of the company or companies that they have invested in.

The other side of the coin, of course, is the potential for gains. The potential gains of an investment are the premium that is paid to an investor in exchange for allowing a company or mutual fund to take risks with the investor’s money.

They say that the riskier the investment, the higher the potential reward, but this may or may not hold true in all situations. Ideally, an investor would diversify his or her portfolio to an extent that risk was minimized for the amount of gain sought, and this is the foundation of modern portfolio theory.

Looking to bonds for an example of risk premium, a bond will have to pay a higher yield if investors perceive that there is more risk involved. The risk-less Treasury bonds will pay the lowest yield because their value is mostly in their safety.

A similar equation holds true in the futures and options market. Investors who seek high returns must be willing to assume higher risk, in general. Even with fully diversified portfolios, systematic market risk will expose investors to random price fluctuations, due to the inherent randomness and volatility of the market.

What is Risk?
What is the Risk/Return Trade-Off?
What is the ‘Risk-Free Rate of Return’?