Systematic risks

When an event or circumstance negatively affects the overall market, it’s known as a type of systematic risk.

Market risk

Market risk is a specific type of systematic risk, which occurs when an investment falls in value due to a market or economic circumstance. As we discussed at the beginning of the Suitability subsection, the Great Recession of 2008 is a good example of market risk. The S&P 500, which is an index (average) of 500 large domestically traded stocks, fell by 38% in 2008. When the market declines by that much in one year, it’s a sign that nearly everything is falling in value.

Even Apple (symbol: AAPL) had a terrible performance in 2008. Although the first iPhone had just been released in 2007, the company’s stock fell 56%. To put this in perspective, if you invested $1,000 in Apple on January 1st, 2008, you would have $440 left at the end of the year. Apple was a good company with a growing business model, but its stock value fell dramatically due to the economic environment. This is an example of market risk.

Although there were some exceptions, most stock prices fell drastically in 2008 (due to market risk). Even well-diversified portfolios, which usually “weather the storm” when faced with various risks, lost significant value. Investors cannot use diversification as a way to avoid market risk. When an event or circumstance negatively affects the general market, it doesn’t matter how diversified an investor is.

Inflation risk

We covered the basics of inflation risk, sometimes referred to as purchasing power risk, in the suitability basics section, but let’s dive a bit deeper into this concept. If you’ve noticed prices slowly going up over time, this is inflation. For example, the median home price in 1950 was around $7,000 but rose to $120,000 50 years later in the year 2000. This is a result of inflation. which occurs naturally over time at an average rate of 2-3% annually.

The government measures inflation through the CPI (consumer price index). Every month, the U.S. Bureau of Labor Statistics captures price changes of goods and services. When prices rise on average, CPI rises (and vice versa). When the Series 7 exam refers to CPI, they’re referring to inflation.

Normal levels of inflation (2-3% annually) are healthy and expected. If inflation levels are higher, it can create problems for the economy. When prices go up more than expected (for example, in late 2021-2022), corporations have a tough time maintaining their profits. Think about it - supplies get more expensive, which forces businesses to raise their prices, which generally drives down demand for their products. Bottom line: high levels of inflation are a short-term problem for common stocks (market values will fall).

Over the long term, the stock market tends to outpace inflation. Inflation may occur, but the Federal Reserve will take action to prevent prices from rising too much. The last time the US experienced significant levels of inflation prior to late 2021/2022 was in the 1980s. Eventually, prices stabilized and the economy recovered. Because inflation tends to last for short periods of time, the stock market typically experiences a higher rate of return than the rate of inflation.

Market risk and inflation risk are the two major types of systematic risk (relating to common stock) that you’ll need to be aware of. Market risk is the most commonly referenced, but keep in mind higher inflation levels can affect common stocks in the short term.