Textbook
1. Common stock
1.1 Introduction and SIE review
1.2 Equity securities & trading
1.3 Suitability
1.3.1 Suitability basics
1.3.2 Benefits
1.3.3 Systematic risks
1.3.4 Non-systematic risks
1.3.5 Typical investor
1.4 Fundamental analysis
1.5 Technical analysis
2. Preferred stock
3. Bond fundamentals
4. Corporate debt
5. Municipal debt
6. US government debt
7. Investment companies
8. Alternative pooled investments
9. Options
10. Taxes
11. The primary market
12. The secondary market
13. Brokerage accounts
14. Retirement & education plans
15. Rules & ethics
16. Suitability
17. Wrapping up
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1.3.3 Systematic risks
Achievable Series 7
1. Common stock
1.3. Suitability

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.

Sidenote
Diversification

To reduce many of the risks of investing, many investors diversify their portfolios. Although most common stocks face the same risks, individual stocks face varying levels of each risk at different points in time.

For example, BP (British Petroleum) experienced a significant decline during the Deepwater Horizon oil spill in 2010. In the 40 days after the oil spill, BP’s market price fell by 51%. If an investor had all of their money invested in BP, they would’ve lost more than half of their account value in less than 2 months.

The Deepwater Horizon oil spill was a result of terrible business decisions and environmental variables. Many companies face the same risks. In the right (or wrong) environment, a few bad choices could result in disaster.

Owning BP stock in 2010 had the potential of wrecking a non-diversified investor. But, what if BP only comprised 2% of an investor’s portfolio? Gains from other investments would likely balance out BP’s losses.

Diversification avoids “keeping all your eggs in one basket.” You wouldn’t want your entire life’s savings destroyed because of a terrible business decision, would you? Instead of betting everything on the performance of one company, it’s best to have money invested in many different organizations and asset classes (like stocks and bonds).

Diversification helps reduce many types of risks. One big exception is systematic risk, which cannot be avoided with diversification. Remember, systematic risk affects the entire market. Therefore, a well-diversified common stock portfolio will still be subject to market risk, no matter how many common stocks it invests in.

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.

Key points

Diversification

  • Investing in multiple asset classes and investments
  • Cannot diversify out of systematic risk

Systematic risk

  • Occurs when an event or circumstance negatively affects the entire market

Market risk

  • An investment is negatively affected by a general downturn in the stock market

Inflation risk

  • Also known as purchasing power risk
  • General prices rise more than expected
  • Common stock tends to outpace inflation over long-term periods

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