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Understanding the types of risks involved in investing is a critical component of preparing for your upcoming securities exam.One cannot make a suitable recommendation to a client without mastering the risks associated with that investment. Saving and investing are not the same. In a savings account, the only risk is that the money will lose purchasing power. When we invest, on the other hand, we take the risk that we could lose the money.
The risk of losing some or all the amount invested is called capital risk. When we buy U.S. Treasury Bonds, we eliminate capital risk, but if we buy corporate bonds or common stock, we face the risk of losing some or all the invested capital. Investing in common stock presents significantly more capital risk than investing in corporate bonds, and, also, a much higher potential return.
Systematic Risk
There are two types of investment risk. Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk.
Market Risk
Market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, global pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market.
Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop.
Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks (or bonds) we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop.
Beta measures market risk. A beta of 1.3 indicates the stock is more volatile than the S&P 500—1.3 times as much, and the S&P 500 is already volatile. A beta of .8 indicates the stock is less volatile than the S&P 500—only 80% as volatile. The higher the beta of a stock, the greater the market risk faced by an investor in that security. Investors following modern portfolio theory and its related tenets believe this is the only type of risk an investor should expect to be compensated for taking.
Why? Because unsystematic risks, explored next, can be diversified and thereby reduced. This type of systematic risk is “non-diversifiable,” and so the more of it one faces, the higher the potential return.
Market risk affects bonds and preferred stock, also. If investors turn against any type of investment, the sudden selling interest depresses the value of whatever they are selling. All securities present market risk to an investor. The only way to avoid market risk is to stay out of the market and invest in insurance and banking products instead.
Natural Event Risk
Natural event risk refers to when a tsunami, earthquake, hurricane, or pandemic has a devastating effect on a country’s economy and possibly the economy of an entire area such as Europe or Southeast Asia.
Unfortunately, natural event risk does not fit neatly under either systematic or unsystematic risks. While a tsunami would have a negative impact on markets overall, many weather-related events hit certain sectors or issuers only, an example of unsystematic risk. For example, food and energy producers are affected by weather events that might not impact other industries. Unlike a tsunami, which impacts entire regions of the globe, a Florida frost primarily impacts orange juice.
In addition, some industries do better after natural disasters such as a flood or hurricane: mold remediation, construction, and disaster recovery, etc.
Interest Rate Risk
Interest rate risk is the risk that interest rates will rise, pushing down the market prices of bonds and other fixed-income securities. A security that is sensitive to this type of risk is referred to as being interest-rate sensitive.
When rates go up, all bond prices fall, but long-term bonds suffer the most. When rates go down, all bond prices rise, but long-term bonds increase the most, regardless of the issuer.
Therefore, a 30-year government bond has no default (credit) risk, but carries more interest rate risk than a 10-year corporate bond. Believe it or not, investors could lose money even on guaranteed U.S. Treasury Bonds if they were to sell after interest rates had risen.
Therefore, even though Treasury Bonds and bank accounts are both guaranteed by the federal government, the former are securities with fluctuating market values while the latter are, literally, “money in the bank.”
The reason investors invest in short-term and intermediate-term bond funds is because many want to reduce interest rate risk. In addition, they may have a shorter time horizon and may need this money in a few years. If so, they cannot risk a drop in market value due to a sudden rise in interest rates. They will sacrifice the higher yield offered by a long-term bond fund, but they will sleep better knowing that rising interest rates would not be as damaging to short-term bond prices.
Preferred stock, a fixed-income security, is also interest-rate sensitive, especially if it is perpetual. A bond approaches maturity more closely every day; therefore, a perpetual preferred stock is even more sensitive to a rise in interest rates than many bonds.
A common way to reduce interest rate risk is to build a bond ladder, which is a fixed-income portfolio with maturities spread evenly among short-term, intermediate-term, and long-term bonds. In this way, when the one-year note matures, its proceeds go toward a 10- or 30-year maturity.
Purchasing Power Risk
Purchasing power risk, also called inflation risk, is the risk that an investor’s purchasing power will decrease over time due to overall increases in consumer prices. If inflation erodes the purchasing power of money, an investor’s fixed return cannot buy what it used to.
Fixed-income investments present purchasing power or inflation risk, and so investors often try to beat inflation by investing in common stock. The ride might be a wild one in the stock market, but the reward is that investors’ portfolios may grow faster than the rate of inflation, whereas a fixed-income payment is fixed.
Retirees living solely on fixed incomes are more susceptible to inflation or purchasing power risk than people in the workforce, since salaries tend to rise with inflation. The longer the retiree must live on a fixed income, the more susceptible she is to inflation risk.
Unfortunately, common stock is often too volatile for investors with shorter time horizons and high needs for liquidity. The solution is often to put most of a retiree’s money into short-term bonds and money market instruments, with a small percentage in large-cap stock, equity income, or growth and income funds.
In addition, blue chip stocks pay dividends, and dividends tend to increase over time. Therefore, putting a reasonable percentage of a retiree’s money into blue chip stocks is not necessarily risky.
Although U.S. Treasury securities eliminate credit/default risk, they present more purchasing power risk than higher-yielding bonds, and, again, all fixed-income securities present more purchasing power risk than common stock.
Call Risk
Many municipal and corporate bonds are callable, meaning that the issuer can retire the bonds before the maturity date by buying them back at a price stated in the indenture or the literature supporting the details of the bond issue.
When interest rates drop, corporate and municipal bond issuers borrow new money at today’s lower rate and use it to pay off current bondholders sooner than expected. This is a call of a bond issue, and the risk that a bond issue will be called is referred to as call risk.
The possible risks for current bondholders are that, first, the bond’s price stops rising in the secondary market, since investors know the call price to be received. Second, they take the proceeds from a bond that was paying, say, 5% and turn it into a 3% payment going forward.
If a bond is not callable, the investor is relieved of call risk. However, callable bonds offer higher yields to investors in exchange for the flexibility the issuer receives to refinance debt at a better rate.
Home mortgages are typically “callable,” but we refer to it as refinancing.
Prepayment and Extension Risk
Prepayment risk is the form of call risk inherent in owning a mortgage-backed security. Like a bond issuer, a homeowner with a mortgage will typically take advantage of a drop in interest rates by refinancing.
On the other hand, if interest rates rise, homeowners will take longer than expected to pay off their mortgages. This scenario is called extension risk.
Since GNMA securities are guaranteed by the U.S. Treasury, their main risk is prepayment—or extension—risk. An investment in FNMA or FHLMC securities has that risk plus credit/default risk.
Reinvestment Risk
Reinvestment risk is the risk that interest rates will drop, forcing bondholders to reinvest at lower rates.
Call risk is associated with the early repayment of principal. Reinvestment risk is an ongoing risk—every six months investors may reinvest at lower rates.
Bond ladders help reduce reinvestment risk. Zero-coupon bonds eliminate it but increase interest rate risk.
Political Risk
Political risk is the risk that an investment’s returns will suffer due to political changes or instability in a country or geographic region.
Investing in emerging markets such as China can be high risk but also diversifying.
Currency / Foreign Exchange Risk
Currency risk is the risk that changes in the relative value of currencies will reduce the value of investments denominated in a foreign currency.
American investors are typically harmed when the value of the dollar strengthens versus the foreign currency in the country where they invest.
Unsystematic Risk
Unsystematic risk applies to a specific issuer or industry space, not the overall market. Diversification can reduce this type of risk.
Business Risk
Business risk is the risk that the company becomes less profitable or unprofitable due to competition, labor issues, inferior products, or obsolescence.
Legislative or Regulatory Risk
Legislative/regulatory risk is the risk that rules, regulations, or tax law changes may negatively affect investments.
Credit/Default Risk
Credit/default risk is the risk that a bond issuer will be unable to make interest or principal payments.
Liquidity Risk
Liquidity risk is the risk that an investor will not be able to quickly sell an investment at an acceptable price.
Opportunity Cost
If we pass up an investment opportunity, the opportunity cost is whatever return we gave up.
Investment Risk Summary
Systematic Risk
- Significance: Affect the overall market
- Notes: Non-diversifiable; Investor must “hedge”
Unsystematic Risk
- Significance: Based on issuer or industry
- Notes: Diversifiable; Buy many securities in many industries
Market Risk
- Significance: Markets panic due to war, weather events, etc.
- Notes: Measured by Beta; Hedge with options, futures, ETFs, etc.
Business Risk
- Significance: How strong is the issuer?
- Notes: Competition, obsolescence; Diversify
Political Risk
- Significance: Emerging markets, e.g., China, Vietnam
- Notes: Unstable political-economic systems; Do not confuse with “legislative risk”
Legislative / Regulatory Risk
- Significance: Changes to laws/regulations
- Notes: Tax code changes, EPA requirements; Could negatively affect stock or bond price
Currency Risk
- Significance: Value of dollar
- Notes: ADRs, international and global investing; Weak dollar makes ADR more valuable
Interest Rate Risk
- Significance: Rates up/Market price down
- Notes: Long-term bonds most susceptible; Preferred stock is rate-sensitive, too
Credit / Default Risk
- Significance: Issuer could fail
- Notes: Credit downgrade lowers price of bond; Low bond prices = high-yield
Purchasing Power Risk
- Significance: Inflation erodes buying power
- Notes: Fixed-income presents purchasing power risk; Affects recent retirees
Reinvestment Risk
- Significance: Investing at varying rates
- Notes: If rates down, investor goes forward at lower rate; Zero-coupons avoid this risk
Liquidity Risk
- Significance: Trying to sell when there are few or no buyers
- Notes: Partnerships and hedge funds are illiquid; Thinly traded stocks less liquid
Opportunity Cost
- Significance: What you sacrifice to invest elsewhere
- Notes: If you give up a 5% T-Bond, 5% is your opportunity cost; Try to do better than 5%
We hope that this article has helped you prepare for your test.
Good Luck on your exam!
The Securities Institute of America
