A company faces two kinds of risk. A firm-specific risk is that a competitor might enter its market and take some of its customers. A market risk is that the economy might enter a recession, reducing sales. Which of these two risks would more likely cause the company's shareholders to demand a higher return? Why?

Understanding firm-specific risk is crucial for students and investors alike. This type of risk is tied to individual companies and can be influenced by events like a new competitor entering the marketplace. Imagine a popular coffee shop on the brink of facing competition from a brand new café setting up across the street. The uncertainty of customer loyalty and potential loss of sales is a direct example of firm-specific risk.

Despite sounding alarming, firm-specific risk is often considered less daunting because it can be mitigated. How? The answer lies in risk diversification, a strategy that involves spreading investments across various industries and companies. If one business experiences a downturn, the effect on an investor's complete portfolio is minimized because they have invested in a wide range of assets that are unlikely to fail simultaneously. Therefore, when faced with firm-specific risks, shareholders may not necessarily require a higher return since the risk can be diversified away.

In contrast to firm-specific risk, systematic risk, also known as market risk, encompasses factors that affect entire markets or economies. An economic recession is a perfect illustration of systematic risk. It's like a tidal wave that could drown many businesses indiscriminately, irrespective of their individual strengths or competitive strategies.

Unfortunately, systematic risk cannot be easily quelled through diversification since it tends to impact all sectors to some extent. It is intrinsic to the very nature of markets, and all participants, from giant corporations to individual investors, are exposed. Given that systematic risk poses a non-diversifiable threat, investors often seek a higher return as compensation for bearing this risk. This is a critical point for students to understand: the inability to mitigate systematic risk through diversification drives the demand for higher returns to tolerate the increased exposure.

The remedy for firm-specific risks, diversification, is a cornerstone concept in investing. The idea is as straightforward as not putting all your eggs in one basket. By investing in a range of assets, sectors, or companies, one can smooth out the volatility and reduce the impact of negative performance in any single investment.

To get a clear picture, picture a garden with a mix of plants. If a disease affects only one type of plant, the others could still thrive, ensuring the garden as a whole remains healthy. That's diversification in action. It's an essential strategy that is particularly effective against firm-specific risk but, regrettably, offers little defense against systematic risk like economic recessions that affect all plants in the metaphorical garden of the economy.

The term 'economic recession' can conjure images of job losses, falling stock markets, and widespread financial distress. It is formally defined as a significant decline in economic activity across the economy lasting longer than a few months. It's observed through various indicators like GDP, income, employment, and retail sales.

An economic recession is an example of systematic risk that equally concerns investors, businesses, and governments. During a recession, the decline is pervasive; consumers spend less, businesses scale back operations, and unemployment rises. This environment of uncertainty elevates the importance of understanding market risks. Investors, anticipating tough times for most companies, are more likely to expect higher returns to justify their investments during such volatile periods. It is a clear demonstration of the impact of economic recession on market expectations and the heightened concern for systematic risk over firm-specific risk.