There are numerous non-systematic risks, or unsystematic risks, to be aware of:
A company’s business revenue declines, typically due to competition or mismanagement.
Applies to:
Common stock values tend to decline when business revenues decline because investors often expect lower future earnings, which can reduce demand for the stock. This is a common risk for common stocks because issuers are required to report their financial results quarterly (on Form 10-Q). Stock prices can fall quickly if those results show declining business revenue. For example, PayPal’s stock price dropped 25% after reporting disappointing revenue in early February 2022.
Ways to hedge:
A common theme across non-systematic risks is that diversification can reduce their impact. If you want to avoid being heavily exposed to business risk in one company (like PayPal), you generally wouldn’t put all your money into that single stock.
A company’s ability to function is impacted by the amount of money it owes to creditors.
Applies to:
Borrowing too much money can significantly hinder business operations. The more a company borrows, the more its interest and repayment obligations can reduce earnings (profitability). Common stock investors pay close attention to earnings, and stock indicators like EPS (earnings per share) are closely tracked. When a company’s EPS declines due to large debt levels, the stock price is also likely to decline.
Ways to hedge:
A lack of diversification negatively impacts an investor’s overall portfolio when the few securities owned lose value.
Applies to:
Concentration risk can apply no matter what type of security an investor holds. When a portfolio isn’t diversified, a large decline in one or a few holdings can have an outsized impact on the overall portfolio.
Ways to hedge:
Currency value fluctuations negatively impact the value of a security.
Applies to:
An investor may be subject to currency exchange risk whether a currency weakens or strengthens. For more clarity on this risk, follow the link above.
Ways to hedge:
The inability to sell a security, or the need to offer it at a significant discount in order to sell it.
Applies to:
A simple way to think about this risk is: if a security is difficult (or impossible) to sell at a reasonable price, it has 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 tends to occur less frequently.
Municipal bonds are generally traded only by residents of the state they’re issued from, which can result in a smaller market and less liquidity. Hedge funds typically have lock-up periods that prevent investors from liquidating for lengthy periods of time. Structured products (except for ETNs) and limited partnerships are not generally traded in the secondary market.
Ways to hedge:
An issuer is unable to make required interest and/or principal payments on its debt obligations.
Applies to:
If you lend your friend money and they never pay you back, your friend has defaulted on the loan. The same idea applies when an investor lends money to an organization by purchasing a bond.
Junk bonds, which are rated BB or below, have a higher risk of default. In general, the lower the debt rating, the more likely a default will occur.
Ways to hedge:
Interest rates fall, leading issuers to refinance by calling older securities with high coupons and reissuing new securities with lower coupons. Investors whose securities are called are then forced to reinvest at a lower rate of return.
Applies to:
Call risk is the worst version of reinvestment risk, but it only applies to callable securities. The securities most likely to be called tend to share these characteristics:
Ways to hedge:
A government agency creates a new rule or regulation that negatively impacts a business or an issuer’s securities.
Applies to:
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 created a rule requiring higher standards for cleaning up drilling sites, energy companies could see declining profits (even if the rule benefits the environment). Declining profits typically lead to lower stock prices.
Ways to hedge:
A law approved by Congress and signed into law by the President negatively impacts a business or an issuer’s securities.
Applies to:
New laws can negatively impact all types of securities. For example, a new law might:
Any of these scenarios would negatively impact the securities involved.
Ways to hedge:
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 by businesses within these countries.
Ways to hedge:
Counterparty risk is the risk that the other party in a financial transaction (the counterparty) will fail to fulfill their end of the agreed-upon deal, resulting in a default on a payment or delivery.
This risk is most common in over-the-counter (OTC) trades because a central clearinghouse does not back the contracts, and they are privately negotiated. Without a third-party guarantee, one side could default, especially during times of market stress and instability. OTC derivatives like swaps and forwards carry counterparty risk.
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