Video: Market Risk and Diversification

In this lesson, delve into the intricacies of market risk and the power of diversification with Nick Palazzolo, CPA. He breaks down the two main types of risk associated with companies: market (systematic, non-diversifiable) and firm-specific (unsystematic, diversifiable) risk. Nick demystifies these concepts by connecting them to real-world events, such as war and political incidents that impact every company, explaining how they cannot be mitigated through diversification. On the flip side, he illuminates how firm-specific risks, like labor strikes or loss of key accounts, can be greatly reduced by spreading investments across a variety of industries. This insightful discussion weaves through portfolio theory and its application in minimizing risks that are within an investor's control, arming you with the knowledge to distinguish between risks and strategize accordingly.

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Video Transcript

Instructor: Nick Palazzolo

Nick Palazzolo is head instructor of ExamPrep.ai CPA Review. Nick's teaching style is engaging & upbeat, combining practical Big 4 tax & assurance expertise with years of 1-on-1 coaching. His lessons are concise and emphasize what you need to know to pass. Whether you're a recent grad or working full-time, we’re confident you can conquer your CPA exams with Nick’s review.

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We have two types of risk generally when we're talking about our companies: market risk, systematic, non-diversifiable - all synonyms. Whenever you see one, think of the other. And then firm-specifics, the same as unsystematic, which is the same as diversifiable. All of these are synonyms.

This risk, again, just by many different names, cannot be eliminated through portfolio theory. Portfolio theory is essentially just diversification. It's the theory that you can eliminate much risk if you have a portfolio of investments, many investments, because if one goes to zero, you've got plenty of others. This risk is generally due to war, inflation, international incidents, political events - all of which affect almost every company, whether they're investing in airlines, Netflix, Disney, or bonds.

This risk is inherent to just operating and existing, being a part of an economy. It's just going to have this effect. This is our first type of risk.

Our second risk can be eliminated through portfolio theory, which is just diversification. This is the firm's or industry's risk that is associated with random causes and can be eliminated through diversification.

You've got a portfolio of bonds, stocks, different investments, crypto, and all different industries. If a strike breaks out and all the telecommunications companies have labor strikes, you don't just hold Verizon, AT&T, T-Mobile - you're holding stocks in every industry. So that risk is going to be significantly minimized. Lawsuits, regulatory actions, the loss of a key account - all of these are specific to one firm or one industry.

This is generally accepted market risk and diversification implements. So take a look, take it all in. And you'll see questions talking about items, talking about situations, scenarios, and it'll ask what type of risk is it? Now you know, and you're ready to jump on it.

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