We already know that with greater risk in the world of securities, comes greater reward.
Obviously, however, that is a double-edged sword.
When it comes to any type of investment, a registered representative always takes potential risk into account for each client, especially from a suitability point of view.
You aren’t going to suggest a product to a client that has a high risk/reward scenario if they are risk-averse, right?
In this section, we are going to look at the various types of risk that play a role in the industry because no securities are completely risk-free.
Risk can be put into two categories: systematic (or inflation) risk and nonsystematic (or business) risk.
Let’s start with the latter.
Nonsystematic or business risk
Some companies thrive while others fail.
That failure could be for any number of reasons from a series of unfortunate events to poor management.
Company failures are amplified in times of economic downturn as well, like during periods of recession.
But what happens when a business fails?
Well, there are payments that need to be made to creditors, for example.
To do that, the company will have to sell its assets.
If any money is left once creditors can be paid, it will then be paid out to those who held shares in the company.
When we talk about business risk, it’s something that applies to companies and industries in a single capacity.
For example, one company might not have the same kind of business risk as another, or a specific industry won’t have the same type of risk another might have.
And that’s why we call this nonsystematic risk.
As an example of a business risk, say a particular company has been charged for fraud when it comes to their financial records.
That could cause a drop in the stock price of company shares.
That affects the company only and not the industry they work in.
One of the best ways for investors to overcome the danger of business risk is by not only concentrating their investments in one company or industry type.
In other words, they must diversify their portfolio of investments.
Systematic or inflation risk
Don’t get caught by the various names associated with systematic or inflation risk.
It’s also referred to as constant dollar or purchasing power risk.
This risk takes place over a period of time and sees a lower purchasing power for fixed-income payments as a result of inflation and the continual rise in prices.
Certain securities can be subject to inflation risk and fail to keep up with it.
These include bonds, preferred stock, fixed annuities, or any other that are considered to be fixed return securities.
Capital risk (nonsystematic)
Also called principal risk, this relates to the money of an investor in a certain stock.
This is also called invested capital.
The risk is that matters that are either related or unrelated to the overall financial strength of the issuer could lead to the investor losing a section or all of their invested capital.
TIming risk (nonsystematic)
Investments can be timed poorly, even if they are made in shares of a company that has excellent potential to generate profits for those investing in it.
This isn’t only related to buying shares in a company but selling them too.
In other words, this risk is seen as either lower gains or perhaps even losses based on the timing alone.
Timing risk affects short-term investors in particular.
For example, should they invest in shares that have reached the top of the market and then they fall, statistics show that it takes around three years to recover the money lost in that situation.
Interest rate risk (systematic risk)
Interest rate fluctuations can have an impact on the investment price of securities and this risk covers their overall sensitivity to it.
There are certain securities where interest rate risk can play a big role, for example, bonds, bond funds, preferred stock, and others that are linked to debt.
Depending on the rise and fall of interest rates, their prices will change with a rise leading to lower prices and a fall, higher prices (it’s an inverse relationship).
The overall bond duration, as in the time it still has to go to reach maturity, is also influenced by interest rate changes.
And it’s more volatile the further out the bond’s maturity is.
The reverse is true for those with short maturities.
Because they are not bought at high premiums or sold with large discounts, the prices of bonds with shorter maturities stay pretty much the same.
For the Series 6 exam, remember to distinguish the difference between price volatility and interest rate volatility.
With interest rate volatility, it’s the short term that proves to be more volatile.
This is because short-term interest rates have frequent changes, so something like the federal fund with daily changes is seen as volatile.
When carrying out bond calculations, duration is something that can be pretty useful.
When we speak of duration, we are talking about the time frame that needs to pass before the bond has effectively paid for itself.
There are more calculations that need to be carried out here.
It’s not just simply taking all the interest payments and adding them together.
You must factor in that they are seen as part of the discounted cash flow.
We learn earlier that duration also plays a part in interest rate changes and how sensitive a bond is to them.
For example, bonds show greater sensitivity when they have a longer duration to maturity.
For an interest-paying bond, the duration is shorter when compared to when it will mature.
That’s because additional interest can be earned by reinvesting the interest payment.
That’s not true of a zero-coupon bond, however.
Here, because there is only one payment made when the bond matures, the duration is always the same as the time of the bond’s maturity.
Reinvestment risk (systematic)
Another kind of systematic risk is that of reinvestment risk.
This happens when interest rates decline.
That leaves bond investors in a position where trying to get the same level of return at the default risk is difficult when they look to reinvest investment proceed distributions.
If a bond or preferred stock is recalled by the issuer, reinvestment risk can be a problem for investors.
It also can affect those bonds that have matured.
For example, in 1978, an investor bought a Treasury bond at 11% with a 30-year maturation.
When the bond reached maturity 30 years later, interest rates had dropped significantly to around 6%.
The proceeds generated by the Treasury bond would be difficult to reinvest at 11% without any default risk.
Market risk (systematic)
Market risk is something that can affect both stocks and bonds.
Here we are talking about the fact that some of the principal invested in the stock market by a client can be lost.
This is down to the overall volatility of the market and it can affect all securities, so cannot be overcome through diversification.
In other words, if something impacts the market, such as a war, for example, every single type of security will be affected.
For the Series 6 exam, remember why market risk is a systematic risk.
That’s simply due to the fact that the market itself is a system.
Credit risk (nonsystematic)
Sometimes called default or financial risk, here the failure of the issuer can lead to an investor losing part, or all of their principal.
While credit risk will vary according to the type of investment product, it’s never applied to equity securities only to debt securities.
Bonds with low credit risk are those that receive backing from the municipalities or the federal government.
These bonds tend to be fairly secure.
The longer the term of the bond, the more risk that investors can expect.
That’s obviously due to the fact that they are held by investors for longer periods than short-term bonds are.
But ratings can help play a role here and many investors that worry about credit risks use them to guide their investments when it comes to bonds.
The two rating agencies that are most often used by investors as guidance are Standard and Poor’s and Moody’s.
As for the overall value of a bond, generally, the value is linked to the credit risk and how much credit risk an investor will take on.
What many investors want are bonds with high ratings from rating agencies.
This means that while the bond will have a lower coupon rate, it is not very likely that it will default and impact the investment.
An investor looking for big yields, however, won’t turn to a bond with the highest credit rating but instead will buy lower-rated bonds.
They take on much more credit risk by doing this but the rewards are far higher too as the coupon rate on the bond is higher.
When you compare investment and speculative-grade debt with their maturity date being equal, there will be a price difference between them.
If the economy is doing well, a bond rated AAA and one rated BB will actually have closer prices.
In times of uncertainty in the economy, the prices will be further apart.
That’s because investors aren’t as willing to invest in a risky manner during an economic downturn compared to when the economy is flourishing.
Also when the economy is performing well, speculative debt is often discounted more.
Let’s look some more at bond ratings from Standard and Poor and Moody’s.
We start with the ratings for bank-grade (or investment grade) bonds from highest-rated to lowest.
- Standard and Poor’s AAA and Moody’s Aaa rated bonds: These are the highest-rated bonds available. They are most likely to be able to pay back both interest and principal.
- Standard and Poor’s AA and Moody’s Aa rated bonds: While not as highly rated as the first group, these are still considered strong bonds to invest in as they have little risk.
- Standard and Poor’s A and Moody’s A rated bonds: These bonds are susceptible to less-than-perfect economic conditions.
- Standard and Poor’s BBB and Moody’s Baa rated bonds: While these are more speculative than any of the other three mentioned above, they still have more than enough capacity
Let’s look at the ratings for speculative (or noninvestment-grade) bonds.
- Standard and Poor’s BB and Moody’s Ba rated bonds: The issuer of this bond might miss interest payments due to the fact that the bonds are speculative.
- Standard and Poor’s AAA and Moody’s Aaa rated bonds: With these bonds, one (or more) interest payments are likely not to be paid out by the issuer.
- Standard and Poor’s AAA and Moody’s Aaa rated bonds: When bonds have this classification, they aren’t currently playing any interest.
- Standard and Poor’s AAA and Moody’s Aaa rated bonds: Bonds with these ratings are in arrears when it comes to interest and principal repayments. The issuer is also in default.
Liquidity risk (nonsystematic)
This risk describes when an investment cannot be sold by a client quickly so as to receive its current market value.
Some clients might need investment options that offer excellent liquidity, so they can generate cash easily by selling them.
Other clients might not need investments that are particularly liquid as they don’t need to sell them quickly and if they do want to sell them, are prepared to wait for the best price.
An example of an investment that’s not quickly turned into cash securities that are thinly traded, for example, real estate, unlisted securities, and non-Nasdaq securities.
All of these would have liquidity risks associated with them.
Social, political, and legislative risks (nonsystematic)
When we talk about legislative risks, we are speaking about how an investment can be impacted due to a change of laws, for example.
That could mean that investors suffer a capital loss because the company in which they have bought shares is impacted by these law changes in a negative way.
There is also a social and political risk that can play a role as well.
Political risk can influence any foreign investments that a client might have and often foreign markets do not bring the same stability as U.S. markets do.
Call risk (systematic)
Call risk is related to investment risk but is a category of its own.
This deals primarily with the issuer and whether they might call a bond that a client has invested in before it reaches maturity.
When this happens, investors can struggle to reinvest the principal returned because finding a bond that has the same rate of return as the previous one might prove difficult.
Call risk often happens when interest rates fall and issuers decide to call a bond that has a higher coupon rate.
There are ways around this, however, specifically through call projection which some bonds do offer.
This is a specific period, which is determined by the issuer and could be 3, 5, or 10 years, for example.
During this period, the issuer may not recall the bond.
Note that bond funds do not suffer from call risk.
That’s because they cannot be called at all.
However, bonds within the portfolio of the bond can be called.
Currency risk (systematic)
Changes in the exchange rate that might affect investments are what currency risk refers to.
This is linked to investors who buy into foreign funds because the performance of the U.S. dollar can play a massive role.
For example, should the dollar outperform the foreign currency linked to the international fund, the investor will lose profit while should the foreign currency outperform the dollar, a profit is made.
TRANSACTION DISCLOSURE REQUIREMENTS
In the world of securities, there are some particular risks that are linked to certain investments and transactions as well as specific costs that customers should know about.
Full disclosure about these risks as well as costs must be brought to the attention of the client if a registered representative is looking to suggest these types of investments to them.
Let’s look at a few examples of things that should be disclosed.
Investments that are illiquid
We’ve touched on this before, but it is worth reminding ourselves again.
A registered representative must disclose any investments that they are suggesting to a client that doesn’t offer much liquidity and will be extremely difficult to sell.
An investment like this is never suitable for clients that want to be able to access their money quickly or specifically want investments that offer liquidity.
Series 6 registered representatives don’t have to really deal with options as it’s outside the scope of what the license allows but they do require special disclosures.
This may appear on the Series 6 exam.
Just remember that a disclosure agreement has to be given to any customer that wants to trade options.
This has to be done before they can trade on their account.
Option income funds, because they are a mutual fund, won’t require that the client signs an options disclosure agreement.
That’s because the customer who owns the shares won’t make any trading decisions.
That’s in the hands of the fund manager.
Deferred sales charges and surrender fees
Before any purchase is completed by a new client, any charges that they might incur should they choose to liquidate their particular investment must be disclosed to them.
For example, with an annuity, this would be surrender fees while “B” share mutual funds will have deferred sales charges applied to them, which we found out earlier is called a back-end load or CDSC.
Both FINRA and SEC are pretty strict about the fact that these disclosures must be made.
Also, FINRA doesn’t want a potential client to liquidate another asset or borrow against it, for example, a residence to generate capital so as to invest in securities.