Suitability looks at a security’s potential benefits and risks to decide whether it’s appropriate for a particular investor. As you work through different investments in this material, it helps to evaluate the BRTI of each security:
Let’s apply BRTI to common stock.
The main benefits of common stock fall into two categories:
Capital appreciation (also called growth or a capital gain) happens when an investment’s value rises above its original purchase price. For example, if you buy a stock at $50 and sell it at $75, you have a $25 capital gain.
Because there’s no ceiling on how high a stock’s price can rise, common stock has unlimited gain potential. As the market climbs, the investor’s potential gain increases. All common stocks are eligible for capital appreciation.
Income from cash dividends is the other way investors can make money with common stock. Most common stocks don’t pay dividends, but larger, well-established companies that are past their major growth phase often do.
For example, McDonald’s Corp. (ticker: MCD) became the largest fast food chain in the U.S. in the 1960s and expanded aggressively internationally. Today, McDonald’s operates in over 100 countries with more than 36,000 stores worldwide and generates roughly $8 billion in profits annually.
If McDonald’s were still expanding as aggressively as it was in the 1960s, it would likely keep most of its profits (called retained earnings) to fund expansion. Instead, it pays roughly 70% of its earnings to shareholders through dividend payments.
Many large dividend-paying companies focus on maintaining or slowly building market share rather than pursuing major expansion. Ask yourself: how much larger can McDonald’s realistically grow from its current global footprint and roughly $25 billion in annual revenue? Companies with long histories and strong reputations like McDonald’s are often called blue chip companies, and they’re the most common type of issuer to pay dividends.
Investing in common stock involves several risks. Risks that affect the entire stock market are called systematic risks. This section covers two systematic risks:
Market risk is the risk that an investment’s value declines because of broader market or economic conditions.
The Great Recession of 2008 is a classic example. Since it occurred 15 years ago, it can be hard to appreciate how severe it was. More recently, you may remember how poorly the stock market performed in 2022 due to the continuing pandemic, supply chain problems, and significant inflation. The S&P 500 index - a common measure of overall stock market performance - was down 19% that year. In 2008, it was down about twice that amount (-38%). A decline of that size in a single year usually means that most stocks are falling at the same time.
Even Apple Inc. (ticker: AAPL) performed terribly in 2008. Although the first iPhone was released in 2007, Apple’s stock fell 56%. If you invested $1,000 in Apple on January 1, 2008, you would have about $440 at the end of the year. Apple was still a strong company with a growing business model, but its stock price dropped sharply because of the economic environment. That’s market risk.
In 2008, most stock prices fell drastically (with a few exceptions). Even well-diversified portfolios - those holding dozens or hundreds of stocks - lost significant value. Unfortunately, diversification doesn’t meaningfully protect you from market risk. When something harms the overall market, it doesn’t matter how many different stocks you own.
Inflation risk (also called purchasing power risk) is the risk that rising prices for goods and services hurt an investment. Unless you were living under a rock in the last few years, you know inflation well. The annual inflation rate in 2022 was the highest in the last 40+ years (since 1981).
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). Inflation is generally considered normal and healthy when CPI is around 2%. Higher inflation can create economic problems.
When prices rise more than expected (for example, in late 2021-2022), corporations often struggle to maintain profits. Supplies become more expensive, businesses raise prices, and demand for their products often falls. In the short term, high inflation tends to hurt common stocks (market values often fall).
Over long periods, stock market returns tend 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 of this dynamic, many long-term investors use common stock as a hedge against inflation.
Non-systematic risks affect specific investments or sectors rather than the entire market. Diversification directly reduces this category of risk.
When investors don’t diversify, they take on concentration risk, which amplifies the non-systematic risks discussed in this section. For example, if all of your money is in one company’s stock, you’re heavily exposed to problems in that business. As you spread your money across more stocks, any single company matters less to your overall results.
We’ll discuss the following in this section:
Companies with significant debt levels (also called being over-leveraged) are subject to financial risk. For example, Tesla Inc. (ticker: TSLA) faced a single $920 million debt payment in 2019 that nearly wiped out a third of their available cash. Although the company’s products were in high demand, it still had to make difficult choices to stay afloat (including laying off 7% of its workforce).
Business risk is the risk that a company struggles with its core business, often due to competition or mismanagement. Radio Shack shows how severe this can become. Although some stores still exist today, Radio Shack’s business peaked in 1999. Over time, it lost customers to companies like Best Buy and Amazon and failed to adapt to changes in technology and consumer behavior. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring their finances.
Regulatory risk is the risk that current or potential government regulation hurts a company’s profitability.
For example, when Mark Zuckerberg (CEO of Meta Platforms Inc.) testified to Congress regarding privacy concerns, Meta stockholders faced regulatory risk. If an agency such as the Federal Trade Commission (FTC) imposed additional privacy rules on social media platforms, Meta could be forced to spend millions updating training, parts of its website, and general business practices. Even when regulation benefits society, compliance is costly and can reduce profits.
Legislative risk occurs when a law or regulation negatively affects an investment. For example, the tariffs imposed by the Trump administration in 2018 increased the cost of doing business with foreign companies from certain countries. Investors experienced legislative risk when the stock market responded negatively to the trade war.
Regulatory and legislative risks are similar, and you’ll unlikely be tested on the differences. However, regulatory risk typically occurs when a government agency regulates a company or industry (e.g., the Environmental Protection Agency regulating oil & gas companies). In contrast, legislative risk occurs when a new law signed by the President impacts an investment (e.g., a new law signed by the President enforces new rules on oil & gas companies).
Political risk occurs when political instability harms an investment. Examples include military coups, threats or acts of war, and mass riots. Political risk can occur anywhere, but it most often affects foreign securities from countries with unstable government structures.
The PRS Group political risk index ranked the United States as the second safest for political risk within the listed countries in the North American and Central American region (Canada was first), and 19th overall. While the U.S. political environment has been volatile for the last several years, it has not significantly impacted the stock market (example 1, example 2).
Earlier in this unit, we discussed how many common stocks trade on exchanges like the New York Stock Exchange (NYSE) and NASDAQ. One benefit of exchange trading is liquidity - the ease with which a stock can be sold for cash. You can generally assume that any exchange-listed security is easy to buy and sell.
Stocks that aren’t listed on exchanges trade in the OTC markets. These markets tend to have fewer participants and lower trading volume. As a result, it may be difficult to sell a lesser-known stock that trades OTC.
Whenever an investor has trouble converting stock into cash, they face liquidity risk (also called marketability risk). Selling an investment with little demand may require the investor to significantly reduce the asking (sale) price.
Here’s a video breakdown of a practice question on non-systematic risks:
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