There are numerous non-systematic risks to be aware of:
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!
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:
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 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 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:
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:
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 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:
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:
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 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:
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, 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:
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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