When an event or circumstance negatively affects the overall market, it’s called systematic risk.
Market risk is a type of systematic risk. It happens when an investment falls in value because of a broad market or economic event.
The Great Recession of 2008 is a clear example. The S&P 500 - an index (average) of 500 large domestically traded stocks - fell by 38% in 2008. A decline that large is a sign that most investments are dropping at the same time.
Even Apple (symbol: AAPL) performed poorly in 2008. Although the first iPhone had been released in 2007, Apple’s stock fell 56%. Put another way: if you invested $1,000 in Apple on January 1, 2008, you’d have $440 at the end of the year. Apple was still a strong company with a growing business model, but its stock price fell sharply because of the overall economic environment. That’s market risk.
Although there were some exceptions, most stock prices fell drastically in 2008 due to market risk. Even well-diversified portfolios - which often “weather the storm” when faced with company-specific risks - lost significant value. Diversification can’t be used to avoid market risk. When an event or circumstance hurts the general market, it affects diversified investors too.
We covered the basics of inflation risk (also called purchasing power risk) in the suitability basics section. Here, we’ll go a bit deeper.
Inflation is the general rise in prices over time. If you’ve noticed prices slowly increasing, you’ve seen inflation in action. For example, the median home price in 1950 was around $7,000 and rose to $120,000 50 years later (in 2000). That increase reflects inflation, which tends to occur naturally over time at an average rate of about 2-3% annually.
The government measures inflation using the CPI (consumer price index). Each month, the U.S. Bureau of Labor Statistics tracks price changes of goods and services. When prices rise on average, CPI rises (and vice versa). When the Series 7 exam refers to CPI, it’s referring to inflation.
Normal inflation (around 2-3% annually) is generally expected. Higher-than-expected inflation can create problems for the economy. When prices rise faster than expected (for example, in late 2021-2022), corporations may struggle to maintain profits. Supplies become more expensive, businesses raise prices, and higher prices often reduce demand. In the short term, high inflation is typically a problem for common stocks (market values may fall).
Over the long term, the stock market tends to outpace inflation. Inflation may rise, but the Federal Reserve can take action to prevent prices from rising too much. Before late 2021/2022, the last period of significant U.S. inflation was in the 1980s. Eventually, prices stabilized and the economy recovered. Because inflation often occurs in shorter bursts, the stock market typically earns a higher long-term return than the inflation rate.
Market risk and inflation risk are the two major types of systematic risk (as they relate to common stock) that you’ll need to know. Market risk is referenced most often, but remember that higher inflation can also hurt common stocks in the short term.
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