We’ve already covered investment risks across multiple chapters. This chapter is meant to be a high-level review of those risks, with links to more detailed explanations.
Risks related to investing can be divided into two general categories:
There are four systematic risks to be aware of:
An economic or geopolitical event (for example, wars or changes in international relations) that causes a broad decline in stock values.
Applies to:
Market risk is primarily a common stock risk. It can also apply to any security that is exercisable or convertible into common stock. Rights, warrants, bullish options, and convertible securities all have a return component tied to common stock values. When stock values fall, the value of these securities typically falls as well.
For convertible securities, only the conversion feature is subject to market risk. If market risk is present, it can reduce the security’s conversion value. The security’s other primary function (the income it produces) is not generally affected by market risk.
Ways to hedge:
Long index put options are often used to hedge market risk. If the overall market declines, index puts tend to gain value. Those gains can help offset losses in a stock portfolio.
Defensive stocks are issued by companies that tend to maintain a large portion of their revenue during economic downturns (a common driver of market risk). Defensive industries include:
*Basic food and clothing items may be referred to as consumer staples.
Precious metals and real estate investments often have an inverse relationship with the stock market. If the market declines, these assets may rise in value, helping offset stock losses in a portfolio.
Prices across the economy rise, which reduces the purchasing power of money.
Applies to:
Many investors - especially those near or in retirement - hold significant amounts of fixed-income securities. These investments often have lower overall risk, but inflation can erode their value. If a bond continues paying the same dollar amount while prices rise, that income buys less over time. In general, higher inflation leads to larger declines in the value of fixed-income securities, and long-term fixed-income securities are typically affected the most.
Ways to hedge:
As discussed in a previous chapter, the stock market has historically outperformed inflation over long periods of time. Between 2006 and 2021, the S&P 500 outperformed the inflation rate 12 out of 15 years. Even so, 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 rises, the interest payments rise as well. Remember: 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, the values of these assets often rise too. Recent real estate markets provide a clear example of this pattern, and you can see it discussed here: noticed these trends.
The market value of fixed-income securities declines when interest rates rise.
Applies to:
Keep the core relationship in mind: interest rates up → fixed-income values down. This risk is directly tied to price volatility and duration, and it’s most significant for long-term securities with low coupons.
Ways to hedge:
When interest rates rise, borrowing becomes more expensive across the economy. That affects governments, businesses, and individuals, and profits can decline when financing costs increase. Similar to inflation’s short-term impact on stocks, rising interest rates can also contribute to short-term market declines. However, markets often recover after rate increases by the Federal Reserve. Some analysts also argue that rising rates benefit common stocks.
Money markets (debt securities with one year or less to maturity) tend to have low interest rate risk. Their short maturities mean proceeds can be reinvested relatively quickly at the new, higher interest rates.
Interest rates fall, and income must be reinvested into new securities with lower yields.
Applies to:
Income-producing securities with high coupons and frequent payments are the most susceptible to reinvestment risk. The logic is straightforward: the more income you receive, the more you may need to reinvest (if you don’t need the cash). The more you reinvest, the more exposure you have to reinvestment risk.
Most income-producing securities pay semiannually, but securities such as mortgage-backed securities that pay monthly are especially exposed.
Ways to hedge:
Zero coupon bonds are not subject to reinvestment risk because they do not pay periodic income. Securities like STRIPS and Treasury receipts, which are long-term zero coupon bonds, pay no income over long periods. With no income to reinvest, reinvestment risk does not apply.
Common stock that does not pay dividends is similarly not subject to reinvestment risk. Dividend-paying stocks could be exposed to small levels of reinvestment risk, but dividend rates on common stock tend to have a loose correlation with interest rate changes. As a result, falling interest rates do not necessarily mean falling dividend rates on common stock.
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