SIE Study Guide Navigation
- SIE Study Guide Home
- 1.1 Regulatory organizations, establishments and participants in the capital market
- 1.2 Structure of capital markets
- 1.3 Understanding economic factors
- 1.4 Types of security offerings
- 2.1 Securities products in capital markets
- 2.2 Various types of investment risk
- 3.1 Settlement, trading, and corporate actions
- 3.2 Compliance considerations and customer accounts
- 3.3 Prohibited activities
- 4.1 Associated persons SRO regulatory requirements
- 4.2 Reportable events and employee conduct
It goes without saying, every investment made comes at a risk.
And that risk equates to the possibility of a financial loss on an investment decision made by an investor.
For every investor that’s made a windfall, there are those who have lost out.
It’s the name of the investment game.
In this section, we are going to look at examples of the most common risks when it comes to investment.
When looking at a market or market segment, this is the risk that applies to it in its entirety.
An excellent example of market risk is a crash in the stock market.
If this happens, even stocks with the best earning potential fall in price as the whole market is driven down.
Market risk is an example of systematic risk.
When looking at a specific company or line of business, this is the risk that applies to it.
For example, an investor only has investments in the travel industry.
Imagine the knocks those investments took at the start of the Covid-19 pandemic.
That’s why investments should never be in just one industry, for example.
This is known as non-systematic risk.
As inflation increases, purchasing power decreases on your investment returns.
This is known as purchasing or inflationary risk.
It’s natural with fixed-income investments, for example.
That’s due to the value of the dollar decreasing.
When we look at investments where cashflows increase as there is a rise in general price levels, that can diminish the rise of inflation but of course, they do have their unique risks.
These types of investments include real estate or commodities.
Remember too that inflation, in general, affects equity by exerting upward pressure on them.
Foreign currency risk
Obviously, this is related to foreign currency but especially when it comes to fluctuations.
How does this affect investors, however?
Well, if they have purchased stock in a non-U.S. firm, dividends will not be declared or paid out in U.S. dollars.
Instead, they will be paid in the country the company was established in.
And factors that affect that currency could in turn have an impact on dividends received.
This risk cover repayment on a loan, for example, if a borrower doesn’t make their scheduled payment.
In terms of bonds, the least risky are AAA-rated.
That’s because the issuers of these bonds have shown over a long period that they meet their financial commitments.
Those with lower credit ratings, however, will present more of a risk.
Note that other credit risks include those funds that hold debt instruments.
Again, this is generally linked to investments in a foreign country or company.
Political changes in that country can have an influence on investments, and more often than not, they decline.
For example, think of a leadership change, where the incoming leader is not pro-capitalism as his predecessor was.
In some cases, investors might even see their capital confiscated.
That’s an extreme example of political risk but one to note, nonetheless.
This type of risk covers the repayment of a debt investment.
Instead of it lasting the full term, it is paid back earlier and that means less interest earned for investors.
This could affect mortgage-based securities (MBS).
These packaged products have portfolios of mortgages and interest income is aquired through these by investors.
These can suffer this type of risk when either the property owner sells the property or refinances once interest rates drop.
Risk mitigation strategies
There is no way to overcome investment risk but there are strategies that investors can use to mitigate the effect thereof.
- Alternative investments
- Rebalancing portfolios
- Sector rotation
The most obvious risk mitigation strategy is diversification.
Successful investors do not only invest in one investment product.
Instead, they spread their investments, covering a range of products and industries that all react differently to certain economic factors.
We’ve covered hedge funds already.
When the market is moving in the wrong direction, having investments in hedge funds can help.
Hedging strategies generally include an option, futures contract, or some other derivative product.
For the most part, while a portfolio loses value, a hedging instrument appreciates instead.
The aim, therefore, is for the hedge’s profit to offset the loss of the portfolio.
Nothing says that an investor only needs to put their money into equity or debt securities.
As part of diversification, which we talked about above, there are many other ways to invest money.
This includes real property, certificates of deposit, fixed annuities, and even things such as artwork and other collectibles.
In general, an investor’s portfolio of investment has a specific allocation of assets.
These are based on the level of risk the investor wants to invest at.
Should one stock or asset class appreciate significantly, the allocation of assets often becomes unbalanced.
This can lead to risk as markets could become volatile due to investors selling off stock to capitalize on that appreciation.
To alleviate that, an investor could opt to rebalance their portfolio.
This can be achieved by both selling and buying particular investments that help to reinstate the earlier target asset allocation.
Most investors rebalance their portfolios anyways and usually once a year.
Moving invested money from a particular business sector to another is termed sector rotation.
For example, an investor might have investments in health care but rotate them to the energy sector.
It’s a way of following the phases of an economy as it moves through various business cycles.
In that way, an investor can ensure their money is in the right sector that should perform during that current cycle.