A Word About Risk
Market Risk: What You Don’t Know Can Hurt You
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 risk in the context of a specific investment or asset class, it is equally critical that investors consider market risk and where we want to start the discussion about risk. Then we will move to other specific risk such as stockholder risk and bondholder risk. Finishing with what we believe is a very detailed and personal way to determine your specific risk and the type of portfolio that meets your risk tolerance, time horizon, liquidity and suitability as an investor. We call that process the
“Investor Metrix Questionnaire™” and each person after completing the questionnaire receives their specific “Investor Metrix Number™”.
What Is Market Risk?
Market risk is sometimes referred to as systematic risk. It 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. Whichever car you choose, you will face certain risks on the road that have nothing to do with the car itself, but may 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.
7 Common Types of Market Risk
Depending on the nature of the investment, relevant market risks may involve international as well as domestic factors. Here are a seven types of market risk:
- Interest rate riskrelates 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.
- Inflation riskis 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. 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.
- Currency riskcomes 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.
- 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.
- Sociopolitical riskinvolves a market’s 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 riskis similar to sociopolitical risk, but tied to the foreign country in which an 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 riskis 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 United States. 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 risk, you can take a number of steps to manage and minimize it.
- Diversify: Like business risk, market risk 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 investments. Stay abreast of global economic trends and developments. If you’re considering investing in a particular sector (for example, aerospace), read about the future of the aerospace industry. If you’re 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.
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.
What is Investment Risk?
- Is it the potential loss of principal on an investment?
- Is it failing to match or beat the returns posted by an important market index?
- Is it receiving highly volatile returns that fluctuates greatly overtime?
- Is it all of these things?
There are several different methods used to calculate the risk offered by an investment. These methods can be very technical often using complex mathematical formulas and terms such as; beta, standard deviation and co-variance. Most importantly, you need to understand that there are many different types of risk and these risks can adversely affect your investments.
Understanding stockholder risks can help you determine whether or to what extent stocks are appropriate for your portfolio.
The first stockholder risk is Market Risk: As you know stocks are volatile and they fluctuate with market changes. For example; when the stock market declines, it tends to pull down the value of most stocks regardless of the strengths of the underlying companies.
The second is Economic Risk: Slower economic growth can cause the price of some investments to decline. For instance, certain industries such as automakers and steel plants cannot easily cut cost during a recession. Thus, the price of their stocks could decline when the economy slows down.
The thirdly is Company Specific Risk: Such risk may affect share prices. For example; major legal action against a company can affect its stock price. Or new technology can make a company’s principal product obsolete.
Understanding Bondholder risk: Although bonds are generally less volatile than stocks they also have some risk.
Interest Rate Risk
Bonds are subject to different risk than stocks but still carry risk such as the risk that the issuer may not be able to pay the interest or principal when it comes due. Remember the cardinal rule of bonds: When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in interest rates (in the U.S. or other world markets) may reduce (or increase) the market value of a bond you hold. Interest rate risk—also referred to as market risk—increases the longer you hold a bond.
Let’s look at the risks inherent in rising interest rates.
Say you bought a 10-year, $1,000 bond today at a coupon rate of 4 percent, and interest rates rise to 6 percent.
If you need to sell your 4 percent bond prior to maturity you must compete with newer bonds carrying higher coupon rates. These higher coupon rate bonds decrease the appetite for older bonds that pay lower interest. This decreased demand depresses the price of older bonds in the secondary market, which would translate into you receiving a lower price for your bond if you need to sell it. In fact, you may have to sell your bond for less than you paid for it. This is why interest rate risk is also referred to as market risk.
Rising interest rates also make new bonds more attractive (because they earn a higher coupon rate). This results in what’s known as opportunity risk—the risk that a better opportunity will come around that you may be unable to act upon. The longer the term of your bond, the greater the chance that a more attractive investment opportunity will become available, or that any number of other factors may occur that negatively impact your investment. This also is referred to as holding-period risk—the risk that not only a better opportunity might be missed, but that something may happen during the time you hold a bond to negatively affect your investment.
Bond fund managers face the same risks as individual bondholders. When interest rates rise—especially when they go up sharply in a short period of time—the value of the fund’s existing bonds drops, which can put a drag on overall fund performance.
Similar to when a homeowner seeks to refinance a mortgage at a lower rate to save money when loan rates decline, a bond issuer often calls a bond when interest rates drop, allowing the issuer to sell new bonds paying lower interest rates—thus saving the issuer money. For this reason, a bond is often called following interest rate declines. The bond’s principal is repaid early, but the investor is left unable to find a similar bond with as attractive a yield. This is known as call risk.
With a callable bond, you might not receive the bond’s original coupon rate for the entire term of the bond, and it might be difficult or impossible to find an equivalent investment paying rates as high as the original rate. This is known as reinvestment risk. Additionally, once the call date has been reached, the stream of a callable bond’s interest payments is uncertain, and any appreciation in the market value of the bond may not rise above the call price.
If you own bonds or have money in a bond fund, there is a number you should know. It is called duration. Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates. Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates.
Refunding Risk and Sinking Funds Provisions
A sinking fund provision, which often is a feature included in bonds issued by industrial and utility companies, requires a bond issuer to retire a certain number of bonds periodically. This can be accomplished in a variety of ways, including through purchases in the secondary market or forced purchases directly from bondholders at a predetermined price, referred to as refunding risk.
Holders of bonds subject to sinking funds should understand that they risk having their bonds retired prior to maturity, which raises reinvestment risk.
Default and Credit Risk
If you have ever loaned money to someone, chances are you gave some thought to the likelihood of being repaid. Some loans are riskier than others. The same is true when you invest in bonds. You are taking a risk that the issuer’s promise to repay principal and pay interest on the agreed upon dates and terms will be upheld.
While U.S. Treasury securities are generally deemed to be free of default risk, most bonds face a possibility of default. This means that the bond obligor will either be late paying creditors (including you, as a bondholder), pay a negotiated reduced amount or, in worst-case scenarios, be unable to pay at all.
Using Ratings Agencies to Assess Default & Credit Risk. There are 10 nationally recognized statistical rating organizations designated by the Securities and Exchange Commission (SEC). These organizations review information about selected issuers, especially financial information, such as the issuer’s financial statements, and assign a rating to an issuer’s bonds—from AAA (or Aaa) to D (or no rating).
Each NRSRO uses its own ratings definitions and employs its own criteria for rating a given security. It is entirely possible for the same bond to receive a rating that differs, sometimes substantially, from one NRSRO to the next. While it is a good idea to compare a bond’s rating across the various NRSROs, not all bonds are rated by every agency, and some bonds are not rated at all. In such cases, you may find it difficult to assess the overall creditworthiness of the issuer of the bond.
Slow Down When You See “High Yield”
Generally, bonds are lumped into two broad categories—investment grade and non-investment grade. Bonds that are rated BBB, bbb, Baa or higher are generally considered investment grade. Bonds that are rated BB, bb, Ba or lower are non-investment grade. Non-investment grade bonds are also referred to as high-yield or junk bonds. Junk bonds typically offer a higher yield than investment-grade bonds, but the higher yield comes with increased risk—specifically, the risk that the bond’s issuer may default.
Inflation and Liquidity Risk
Inflation risk is the risk that the yield on a bond will not keep pace with purchasing power (in fact, another name for inflation risk is purchasing power risk). For instance, if you buy a five-year bond in which you can realize a coupon rate of 5 percent, but the rate of inflation is 8 percent, the purchasing power of your bond interest has declined. All bonds but those that adjust for inflation, such as TIPS, expose you to some degree of inflation risk.
Liquidity risk is the risk that you will not be easily able to find a buyer for a bond you need to sell. A sign of liquidity, or lack of it, is the general level of trading activity: A bond that is traded frequently in a given trading day is considerably more liquid than one which only shows trading activity a few times a week.
Some bonds, like U.S. Treasury securities, are quite easy to sell because there are many people interested in buying and selling such securities at any given time. These securities are liquid. Others trade much less frequently. Some even turn out to be “no bid” bonds, with no buying interest at all. These securities are illiquid.
Mergers, acquisitions, leveraged buyouts and major corporate restructurings are all events that put corporate bonds at risk, thus the name event risk.
Other events can also trigger changes in a company’s financial health and prospects, which may trigger a change in a bond’s rating. These include a federal investigation of possible wrongdoing, the sudden death of a company’s chief executive officer or other key manager, or a product recall. Energy prices, foreign investor demand and world events also are triggers for event risk. Event risk is extremely hard to anticipate and may have a dramatic and negative impact on bondholders.
Assessing your risk tolerance is a major consideration of a sound investment strategy. If you have a high tolerance for risk you may want a higher concentration of growth investments in your portfolio such as stocks. If you have a low risk tolerance for risk tolerance for risk and are more concerned with preserving your principal, you may want lower risk investments in your portfolio such as bonds or cash alternatives. Generally, the more potential for growth offered by an investment the more risk it carries. The investment return and principal value of stocks and bonds will fluctuate with changes in market conditions. Shares when sold may be worth more or less than their original cost. Bonds redeemed prior to maturity maybe worth more or less than the original amount investment.
Your Flexible Personalized
Our Investor Metric Questionnaire™ is the foundation of building your personalized risk adjusted portfolio which keeps your portfolio within your stated comfort zone throughout your investment time frame. We start by defining your personalized Investor Metric Number™, based on our unique behavior finance questionnaire which considers the following:
- Risk tolerance
- Time horizon
- Goals & objectives
This Investor Metric Number™, is then mapped to one of six portfolios which are constructed by starting out with the time tested Modern Portfolio theory to determine the appropriate asset allocation for each investor type. Then we continue with our proprietary fundamental & technical analysis, which is applied to the entire universe of ETF’s to narrow the group down to include only the best of the best. Then our proprietary screens select the lowest ETF’s for each portfolio from the best of the best. We finish right where we started, with risk in mind and for this we turn to BlackRock. Back by Aladdin®, BlackRock proprietary risk management engine allows us to see what is contributing to risk in a portfolio. Trusted by institutional investors, corporation and governments around the world.
This Investor Metric Number™, represents the amount of risk you’re comfortable taking on in exchange for potential returns.
Think of your Investor Metric Number™ like the above thermostat which is found in most homes. In that, each person has a temperature comfort zone. Let’s say in the winter you want your home to stay at a comfort level of 78 degrees regardless of how cold it is outside. So you set your thermostat to 78 degrees – thus your boiler will work hard to maintain this temperature and you don’t keep checking the thermostat to determine if it’s set to 78 every time the news media says it’s freezing outside! Or a winter advisory warning is in force until the morning! The same should be true about your personal portfolio. Now that you have an Investor Metric Number™, you will know your investor this number helps you and us to know your investment risk tolerance and comfort zone and the portfolio that you select will be managed to keep you within your comfort zone throughout your investment time frame regardless if the news media announces the DOW Jones drops -300 points! Or the market is crashing! Or a neighbor states her/she earned +23% and you begin to thing I did not earn that without knowing if that is true or what type of investor they are or the amount of risk they are taking to get that rate of return. In addition, if you hear the market is up +23% and your portfolio may be lower than that and you begin to wonder why didn’t I earn that rate of return in my portfolio. The reasons maybe simple as your portfolio was not constructed to track that stated index. But, it was constructed to meet your personal risk tolerance, time horizon, liquidity needs, suitability and goals & objectives. Therefore, you more than likely will not see returns identical to the index to equal to your neighbors quoted rate of return and that should not be expected. The only way to match these indexes one would have to have their investments in an index that tracks these indexes entirely. A practice that many follow, however, this no longer makes it a personalized portfolio designed to meet your personal risk tolerance, time horizon, liquidity, suitability and/or goals & objectives. As these indexes are either narrow in that of the DOW Jones industrial index made up of only 30 companies. Or very broad in that of the S&P 500 index which is made up of 500 companies is some many industries throughout the country. However, once your account is opened if you would like a portion of your assets to be invested to track a specific index like the DOW Jones Industrial Average or the S&P 500 you can specify that to us and we will direct your assets accordingly to achieve this stated goal and/or objective.
The bottom line is all investments carry some degree of risk. By better understanding the nature of risk, and taking steps to manage those risks, as well as, your own specific comfort zone in relationship to risk and volatility you put yourself in a better position to meet your financial goals. This way you be able to take advantage of the different types of risk instead of being subject to it!
Investor Metric Number™ [1-11]
GOAL:Preservation of capital with low to moderate volatility.
INVESTMENTS:20% Equity/80% Fixed Income
INVESTOR PROFILE:For Investors who want current income and stability in their portfolio.
Investor Metric Number™ [12-24]
GOAL:Preservation of capital with moderate volatility.
INVESTMENTS:35% Equity/65% Fixed Income
INVESTOR PROFILE:For Investors who want current income and stability with some growth.
Investor Metric Number™ [20-46]
GOAL:Seeks balance between long-term growth of capital with moderate volatility.
INVESTMENTS:50% Equity/50% Fixed Income
INVESTOR PROFILE:For Investors looking for stable returns.
Investor Metric Number™ [66-92]
GOAL:Seeks long-term high moderate growth of capital
INVESTMENTS:80% Equity/20% Fixed Income
INVESTOR PROFILE:For Investors who do not need current income and want high growth.