Suitability relates to a security’s benefits and risks, and is used to determine if an investment is appropriate for a particular investor. When we cover various investments throughout this material, it’s important to understand the “BRTI” of the securities covered:
Let’s dive into the BRTI of common stock!
The primary benefits of common stock can be boiled down to two basics: capital appreciation and income.
Capital appreciation, also known as growth or a capital gain, occurs when an investment’s value rises above its original purchase price. For example, a stock purchased at $50 and sold at $75 results in a $25 capital gain. With no ceiling to how high the stock market can climb, common stock has unlimited gain potential. The further the market climbs, the more the investor gains. All common stocks are eligible for capital appreciation.
Income from cash dividends is the other way to make money on common stock. While most common stocks do not pay dividends, larger, well-established companies beyond their major growth phase usually do.
For example, McDonald’s Corp. (ticker: MCD) became the largest fast food chain in the U.S. in the 1960s and aggressively expanded its business 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 retain all profits (known as retained earnings) and use the money for business expansion. Instead, it pays roughly 70% of its earnings to shareholders through dividend payments.
Many large dividend-paying companies attempt to retain or slowly build their market share, but significant business expansions are typically not in their plans. Think about it - how much do you expect McDonald’s business to grow beyond its current state? The company already has a global presence and generates roughly $25 billion in annual revenue. Organizations with similar histories and structures as McDonald’s are known as blue chip companies, and are the most common type of issuer to pay dividends.
Investing in common stock involves several unique risks. Risks that apply to the entire stock market are known as systematic risks. We’ll cover these two systematic risks in this section:
Market risk occurs when an investment’s value declines due to a market or economic circumstance. The Great Recession of 2008 is an excellent example of market risk. It occurred 15 years ago, so it’s difficult for some learners (especially those that are younger) to understand how bad it really was. With 2022 still in the rear-view mirror, you may recall how poorly the stock market performed due to the continuing pandemic, supply chain problems, and significant inflation. The S&P 500 index, the most common measure of the stock market’s performance, was down 19%. In 2008, it was down twice that amount (-38%). When the market declines by that much in one year, it’s a sign that nearly everything is falling in value.
Even Apple Inc. (ticker: AAPL) had a terrible performance in 2008. Although the first revolutionary iPhone was just released in 2007, the company’s stock fell 56%. 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. Even well-diversified portfolios (those invested in dozens or hundreds of stocks) lost significant value. Unfortunately, diversification does not meaningfully help an investor avoid market risk. When an event or circumstance negatively affects the general market, it doesn’t matter how diversified an investor is.
Inflation risk, sometimes referred to as purchasing power risk, occurs when rising goods and services prices negatively impact 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 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). Inflation is considered standard and healthy for the economy when CPI hovers around 2%. Higher inflation levels can create economic problems.
When prices go up more than expected (e.g., 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. High inflation levels are a short-term problem for common stocks (market values will fall).
Over long periods, stock market returns tend to outpace inflation. Inflation may occur, but the Federal Reserve will take action to prevent prices from rising too much. The last time the U.S. experienced significant inflation levels before late 2021/2022 was in the 1980s. Eventually, prices stabilized, and the economy recovered. Because of this dynamic, many long-term investors utilize common stock as a hedge against inflation.
Non-systematic risks affect specific investments or sectors, not the entire market. Diversification directly reduces and mitigates this category of risk. When investors lack diversification, they are subject to concentration risk, which amplifies the non-systematic risks we will discuss in this section. For example, an investor with all their money in one company’s stock is greatly impacted if the business faces problems. However, the more stocks they own, the less they’re concerned about one company’s performance.
We’ll discuss the following in this section:
Stocks of companies with significant debt levels (also known as 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 occurs when a company has difficulty with its general business, typically due to competition or mismanagement. Radio Shack is a good example of how this risk can become a huge problem. Although some stores are still around today, Radio Shack’s business peaked in 1999. Over the years, they lost customers to companies like Best Buy and Amazon while failing to evolve with the changing technological landscape. Eventually, Radio Shack filed for Chapter 11 bankruptcy in 2015, and again in 2017 after restructuring their finances.
When a company faces challenges due to current or potential government regulation, investors experience regulatory risk. When Mark Zuckerberg (CEO of Meta Platforms Inc.) was asked to testify to Congress regarding privacy concerns, Meta stockholders faced regulatory risk if a government agency like the Federal Trade Commission (FTC) enforced additional rules related to privacy on social media platforms. The company would be forced to spend millions of dollars updating training protocols, aspects of its website, and general business practices. While it may be good for society, complying with regulations is costly and drives down 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 materializes when political instabilities negatively impact an investment. Examples include military coups, threats or acts of war, and mass riots. While political risk can happen anywhere, it primarily 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 US political arena 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 of the benefits of trading on an exchange is liquidity - the ease with which a stock can be sold for cash. You can safely assume any exchange-listed security is easy to buy and sell.
Stocks that are not listed on exchanges trade in the OTC markets. These non-exchange markets tend to have less trading volume and participants. Consequently, it may be difficult for an investor to sell a lesser-known stock trading in the OTC markets. Whenever an investor has trouble turning their stock into cash, they face liquidity risk, sometimes referred to as marketability risk. Selling an investment with little or no demand may require the investor to substantially drop their asking (sale) price.
Here’s a video breakdown of a practice question on non-systematic risks:
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