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.
There are four systematic risks to be aware of:
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:
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 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.
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.
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.
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.
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