Types of risk
We’ve already discussed risks across multiple chapters in this material. This chapter should primarily serve as a high level review of those risks. Links to more detailed descriptions will be provided.
Risks related to investing can be divided into two general categories. Systematic risks exist when a market-wide circumstance or event may result in an investment loss. Generally speaking, all securities within a market are subject to systematic risks. Non-systematic risks exist when a circumstance or event related to a specific security or a small sector of the market may result in an investment loss. This type of risk tends to apply on a security-by-security basis.
Systematic risks
There are four systematic risks to be aware of:
- Market risk
- Purchasing power (inflation) risk
- Interest rate risk
- Reinvestment risk
Market risk
An event or circumstance, typically economic or geopolitical (e.g. wars, relations with other countries), which results in the general decline of stock values.
Applies to:
- Common stock
- Rights
- Warrants
- Bullish options (long calls and short puts)
- Convertible preferred stock
- Convertible bonds
Market risk is primarily a common stock risk. Technically, this type of risk also could apply to any security that is exercisable or convertible into common stock. Rights, warrants, bullish options, and convertible securities all involve a component of return tied to common stock values. If stock values fall, so do the value of these securities.
Only one aspect of convertible securities are subject to market risk - the conversion feature. If market risk exists, it could negatively affect the security’s conversion value. Otherwise, the primary function of these securities (the income they produce) is not generally affected by market risk.
Ways to hedge:
Long index put options are utilized as hedges against market risk. If the general market declines, index puts gain value for their holders. The gains from the option could be used to offset the losses from stocks.
Defensive stocks are issued by companies that typically maintain much of their business revenue during economic downturns (a major cause of market risk). Defensive industries include:
- Basic food & clothing items*
- Pharmaceuticals (medication)
- Utilities (electricity, water, etc.)
- Alcohol and tobacco products
*Basic food and clothing items may be referred to as consumer staples.
Precious metals and real estate investments tend to have an inverse relationship with the market. Therefore, an increase in value could be expected if the market generally declines, offsetting stock losses in an investor’s portfolio.
Purchasing power (inflation) risk
General prices across the economy rise, resulting in declining purchasing power.
Applies to:
Some investors, especially those of retirement age, invest significant sums in fixed-income securities. While these securities tend to be subject to lower levels of risk overall, inflation can erode their value. Investments like bonds lose value when they continue to pay the same amount of income in the face of rising prices in the economy. The more inflation, the more fixed-income securities decline in value. Long-term fixed income securities are the most affected.
Ways to hedge:
As we’ve discussed in a previous chapter, the stock market historically outperforms inflation over long periods of time. In the period between 2006 and 2021, the S&P 500 outperformed the inflation rate 12 out of 15 years. Regardless, you should keep in mind inflation can still disrupt the stock market in the short term.
TIPS are the only long-term debt security that does not face inflation risk. As inflation rates rise, so do the interest payments. As a reminder, the par value of TIPS is adjusted every six months, while the coupon stays fixed.
Precious metals and real estate investments tend to have a positive relationship with inflation. When inflation rises, so do the values of these assets. If you’ve paid attention to the real estate market in the past few years, you’ve likely noticed these trends.
Interest rate risk
Market values of fixed-income securities decline due to rising interest rates.
Applies to:
Try to make this risk as simple as possible - interest rates up, fixed income values down. This type of risk is directly tied to price volatility and duration, both of which are most applicable to long-term securities with low coupons.
Ways to hedge:
Interest rate increases result in higher borrowing costs across the economy, which affects governments, businesses, and people. Profits simply decrease when borrowing money is more expensive (nearly every organization and person borrows money in some form). Similar to inflation’s negative influence on the stock market in the short term, rising interest rates can result in short-term declines as well. However, the market tends to recover soon after rates are raised by the Federal Reserve). Some analysts even make an argument that rising rates benefit common stocks.
Money markets, which are debt securities with 1 year or less to maturity, tend to be subject to low levels of interest rate risk. This type of security arguably acts as a hedge for investors hoping to avoid this risk due to its short-term nature. Money markets mature in a short period of time, and those maturity proceeds can be reinvested back into the market at a higher rate of interest.
Reinvestment risk
Interest rates fall, forcing reinvestment of income into new securities with lower yields.
Applies to:
Income-producing securities with high coupons and frequent payments are the most susceptible to reinvestment risk. Think about it - the more income an investor receives, the more they’ll have to reinvest if they don’t need the cash. The more they reinvest, the more they’ll be subject to this risk. Most income-producing securities pay income semi-annually, but securities like mortgage-backed securities that pay income monthly are especially subject to reinvestment risk.
Ways to hedge:
Zero coupon bonds are not subject to reinvestment risk as they do not pay income. Securities like STRIPS and Treasury receipts, which are long term zero coupon bonds, don’t pay income over lengthy periods of time. With no income to reinvest, this risk does not apply.
Common stock investments that do not pay dividend income similarly are not subject to this risk. However, it could be argued that dividend-paying stocks may be subject to small levels of this risk. However, dividend rates on common stock tend to have a loose correlation with interest rate fluctuations. Therefore falling interest rates may not necessarily correlate with falling dividend rates on common stock.
Non-systematic risks
There are numerous non-systematic risks to be aware of:
- Business risk
- Financial risk
- Concentration risk
- Currency exchange risk
- Liquidity (marketability) risk
- Default (credit) risk
- Call risk
- Regulatory risk
- Legislative risk
- Political risk
Business risk
A company’s business revenue declines, typically due to competition or mismanagement of the company.
Applies to:
Common stock values tend to decline when business revenues decline, which results in less demand for their stock. This is a fairly common risk for common stocks as issuers are required to report their financial results quarterly (on Form 10-Q). Stock prices can fall quickly if financial results reflect declining business revenue. For example, PayPal’s stock price dropped 25% after reporting disappointing revenue in early February 2022.
Ways to hedge:
You’ll notice a trend when we go through non-systematic risks. All of them can be drastically reduced through diversification. Want to avoid business risk on PayPal stock? Don’t put all your money in PayPal stock. Diversify!
Financial risk
A company’s ability to function is impacted by the amount of money it owes to creditors.
Applies to:
Borrowing too much money can hinder business operations significantly. The more a company borrows, the more it impacts its earnings (profitability). Common stock investors are focused on a company’s earnings, as stock indicators like EPS (earnings per share) are closely tracked. When a stock’s EPS declines due to large debt levels, it’s likely the stock price will decline as well.
Ways to hedge:
Concentration risk
A lack of diversification negatively impacts an investor’s overall portfolio when the few securities owned lose value.
Applies to:
- All securities
Concentration risk can apply no matter the type of security an investor dabbles in. When an investor isn’t diversified, a large decline in one or a few securities can have a significant impact on their overall portfolio.
Ways to hedge:
Currency exchange risk
Currency value fluctuations negatively impact the value of a security.
Applies to:
An investor may be subject to currency exchange risk, regardless of whether a currency weakens or strengthens. For more clarity on this risk, follow the link above.
Ways to hedge:
Liquidity (marketability) risk
The inability to sell a security or a requirement to offer a security at a significant discount to sell it.
Applies to:
Keep it simple - if a security is difficult or impossible to sell at a decent price, it’s subject to liquidity (marketability) risk. High-risk securities like penny stocks and junk bonds are only suitable for the most aggressive investors. When only a small portion of the market is suitable for a security, trading occurs less frequently. Municipal bonds are generally traded only by residents of the state they’re issued from, which results in a smaller market and less liquidity. Hedge funds typically have lock-up periods that prevent investors from liquidations for lengthy periods of time. Structured products (except for ETNs) and limited partnerships are not generally traded in the secondary market.
Ways to hedge:
Default (credit) risk
An issuer is unable to make required interest and/or principal payments on its debt obligations
Applies to:
- Debt securities (in general)
- Junk bonds (in particular)
If you lend your friend money and they never paid you back, your friend defaulted on their loan. The same situation applies when an investor lends money to an organization by purchasing a bond. Junk bonds, which are rated BB or below, are at higher risk of default. The lower the debt rating, the more likely a default will occur.
Ways to hedge:
Call risk
Interest rates fall, resulting in issuers refinancing by calling older securities with high coupons and reissuing new securities with lower coupons. Investors being called are then forced to reinvest back into the market at a lower rate of return.
Applies to:
Call risk is the worst version of reinvestment risk, but only applies to callable securities. The securities most likely to be called tend to share these characteristics:
- Long maturities
- High coupons
- Low call premiums
Ways to hedge:
Regulatory risk
A government agency creates a new rule or regulation that negatively impacts a business or an issuer’s securities.
Applies to:
- Common stock (sector)
Regulations tend to apply on a sector-by-sector basis. For example, the Environmental Protection Agency (EPA) regulates energy companies (e.g. oil, natural gas) in order to protect the environment. If the EPA were to create a rule that required higher standards for cleaning up drilling sites, it would result in declining profits for energy companies (although it might be good for the environment). Declining profits typically leads to lower stock prices.
Ways to hedge:
Legislative risk
A law approved by Congress and signed into law by the President negatively impacts a business or an issuer’s securities.
Applies to:
- All securities
New laws can negatively impact all types of securities. For example, what if a new law required the IRS to tax income on municipal bonds? Or, required the SEC to regulate hedge funds? Or, disallowed many of the tax benefits provided by limited partnerships? Any of these scenarios would negatively impact the securities involved.
Ways to hedge:
Political risk
An unstable government structure negatively impacts a business or issuer’s security.
Applies to:
Although the US has faced its own governmental issues, truly unstable governments tend to be outside of the US. A lack of a strong or independent governmental structure can lead to coups, nationalization of sectors, or invasions from other countries. These actions could result in losses for securities issued by these governments or businesses within these countries.
Ways to hedge:
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