Market Risk: What You Don't Know Can Hurt You
When the Chinese stock market dropped by 9% during a single day in late February 2007, markets around the world quickly felt the impact. In the U.S., the Dow Jones Industrial Average fell by 4.3%, its worst decline since the aftermath of the September 11, 2001 terrorist attacks.
These events underscore how important it is for investors to understand the concept of market risk, which, like the Chinese stock market example, can result in a volatility in one market impacting other markets. Most investors know that investing involves risks as well as rewards and that, generally speaking, the higher the risk, the greater the potential reward. While it is important to consider the risks in the context of a specific investment or asset class, it is equally critical that investors consider market risk.
We issued this Investor Alert—which was also published for investors around the world through the efforts of the International Organization of Securities Commissions—to outline the different types of market risks your investments may be exposed to and to describe steps you can take to minimize or manage those risks.
What Is the Difference Between Business Risk and Market Risk?
Risks associated with investing in a particular product, company, or industry sector are called business or "non-systematic" risks. Common business risks include:
- Management Risk—also called company risk, encompasses a wide array of factors than can impact the value of a specific company. For example, the managers who run the company might make a bad decision or get embroiled in a scandal, causing a drop in the value of the company's stocks or bonds. Alternatively, a key competitor might release a better product or service.
- Credit Risk—also called default risk, is the chance that a bond issuer will fail to make interest payments or to pay back your principal when your bond matures.
By contrast, market risk, sometimes referred to as systematic risk, involves factors that affect the overall economy or securities markets. It is the risk that an overall market will decline, bringing down the value of an individual investment in a company regardless of that company's growth, revenues, earnings, management, and capital structure.
Here's an illustration of the concept of market risk: Let's say you decide to buy a car. You can buy a brand-new car under full warranty. Or you can buy a used car with no warranty. Your choice will depend on a variety of factors, like how much money you want to spend, which features you want, how mechanical you are, and, of course, your risk tolerance. As you research different vehicles, you'll find that some makes and models have better performance and repair histories than others.
But whichever car you chose, you will face certain risks on the road which have nothing to do with the car itself, but which can significantly impact your driving experience—including the weather, road conditions, even animals crossing the highway at night. While these factors may be out of your control, being aware of them can help prepare you to navigate them successfully.
What Are Common Market Risks?
Depending on the nature of the investment, relevant market risks may involve international as well as domestic factors. Key market risks to be aware of include:
- Interest Rate Risk relates to the risk of reduction in the value of a security due to changes in interest rates. Interest rate changes directly affect bonds—as interest rates rise, the price of a previously issued bond falls; conversely, when interest rates fall, bond prices increase. The rationale is that a bond is a promise of a future stream of payments; an investor will offer less for a bond that pays-out at a rate lower than the rates offered in the current market. The opposite also is true. An investor will pay a premium for a bond that pays interest at a rate higher than those offered in the current market.
For instance, a 10-year, $1,000 bond issued last year at a 4% interest rate is less valuable today, when the interest rate has gone up to 6%. Conversely, the same bond would be more valuable today if interest rates had gone down to 2%.
- Inflation Risk is the risk that general increases in prices of goods and services will reduce the value of money, and likely negatively impact the value of investments.
For instance, let's say the price of a loaf of bread increases from $1 to $2. In the past, $2 would buy two loaves, but now $2 can buy only one loaf, resulting in a decline in purchasing power of money.
Inflation reduces the purchasing power of money and therefore has a negative impact on investments by reducing their value. This risk is also referred to as Purchasing Power Risk. Inflation and Interest Rate risks are closely related as interest rates generally go up with inflation. To keep pace with inflation and compensate for loss of purchasing power, lenders will demand increased interest rates.
However, you should note that inflation can be cyclical. During periods of low inflation, new bonds will likely offer lower interest rates. During such times, investors looking only at coupon rates may be attracted to investing in low-grade junk bonds carrying coupon rates similar to the ones that were offered by ordinary bonds during inflation period. Investors should be aware that such low-grade bonds, while they may to a certain extent compensate for the low inflation, bear much higher risks.
- Currency Risk comes into play if money needs to be converted to a different currency to purchase or sell an investment. In such instances, any change in the exchange rate between that currency and U.S. dollars can increase or reduce your investment return. This risk usually only impacts you if you invest in stocks or bonds issued by companies based outside the United States or funds that invest in international securities.
For example, assume the current exchange rate of US dollar to British pound is $1=£0.53. Let's say we invest $1,000 in a UK stock. This will be converted to the local currency equal to £530 ($1,000 x £0.53 = £530). Six months later, the dollar strengthens and the exchange rate changes to $1=£0.65. Assuming that the value of the investment does not change, converting the original investment of £530 into dollars will fetch us only $815 (£530/£0.65 = $815). Consequently, while the value of the stock remains unchanged, a change in the exchange rate has devalued the original investment of $1,000 to $815. On the other hand, if the dollar were to weaken, the value of the investment would go up. So if the exchange rate changes to $1 = £0.43, the original investment of $1,000 would increase to $1,233 (£530/£0.43 = $1,233).
- Liquidity Risk relates to the risk of not being able to buy or sell investments quickly for a price that tracks the true underlying value of the asset. Sometimes you may not be able to sell the investment at all—there may be no buyers for it, resulting in the possibility of your investment being worth little to nothing until there is a buyer for it in the market. The risk is usually higher in over-the-counter markets and small-capitalization stocks. Foreign investments pose varying liquidity risks as well. The size of foreign markets, the number of companies listed and hours of trading may be much different from those in the U.S. Additionally, certain countries may have restrictions on investments purchased by foreign nationals or repatriating them. Thus, you may: (1) have to purchase securities at a premium; (2) have difficulty selling your securities; (3) have to sell them at a discount; or (4) not be able to bring your money back home.
- Sociopolitical Risk involves the impact on the market in response to political and social events such as a terrorist attack, war, pandemic, or elections. Such events, whether actual or anticipated, affect investor attitudes toward the market in general, resulting in system-wide fluctuations in stock prices. Furthermore, some events can lead to wide-scale disruptions of financial markets, further exposing investments to risks.
- Country Risk is similar to the Sociopolitical Risk described above, but tied to the foreign country in which investment is made. It could involve, for example, an overhaul of the country's government, a change in its policies (e.g., economic, health, retirement), social unrest, or war. Any of these factors can strongly affect investments made in that country. For example, a country may nationalize an industry or a company may find itself in the middle of a nationwide labor strike.
- Legal Remedies Risk is the risk that if you have a problem with your investment, you may not have adequate legal means to resolve it. When investing in an international market, you often have to rely on the legal measures available in that country to resolve problems. These measures may be different from the ones you may be used to in the US. Further, seeking redress can prove to be expensive and time-consuming if you are required to hire counsel in another country and travel internationally.
How Can I Manage Risk?
While you cannot completely avoid market risks, you can take a number of steps to manage and minimize them.
- Diversify: As in the case of business risks, market risks can be mitigated to a certain extent by diversification—not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holdings (short- and long-term). You can spread your international risk by diversifying your investment over several different countries or regions.
- Do Your Homework: Learn about the forces that can impact your investment. Stay abreast of global economic trends and developments. If you are considering investing in a particular sector, for example, aerospace, read about the future of the aerospace industry. If you are thinking about investing in foreign securities, learn as much as you can about the market history and volatility, socio-political stability, trading practices, market and regulatory structure, arbitration and mediation forums, restrictions on international investing and repatriation of investment.
Learn more about the various types of investments options available to you and their risk levels. Inflation risk can be managed by holding products that provide purchasing power protection, such as inflation-linked bonds. Interest rate risk can be managed by holding the instrument to maturity. Alternatively, holding shorter term bonds and CDs provide the flexibility to take advantage of higher paying instruments if interest rates go up.
Some investments are more volatile and vulnerable to market risks than others. Selecting investments that are less likely to fluctuate with changes in the market can help minimize risks to a certain extent.
Investments involve varying levels and types of risks. These risks can be associated with the specific investment, or with the marketplace as a whole. As you build and maintain your portfolio, remember that global events and other factors you cannot control can impact the value of your investments. And be sure to take both business risks and market risks into account.
For more information on making informed investment decisions, be sure to read our Smart Investing series, including:
- Smart Bond Investing—covers the basics of bond investing and also provides Risk Report Cards for individual bonds and easy access to real-time bond
- Smart 401(k) Investing—provides answers to questions about saving for retirement, including risk, asset allocation, and diversification
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