SIE Prep Part 23 - Investment Risks

Introduction to Investment Risks

  • Purpose: Prepare for the Securities Industry Essentials (SIE) Exam.

  • Focus: Investment risks, specifically systematic, unsystematic, portfolio strategies, and hedging.

Types of Investment Risks

Systematic Risk

  • Definition: Non-diversifiable risk; affects the entire market.

  • Explanation: Investors cannot reduce systematic risk through diversification.

  • Example: Market drop on March 13, 2020, during the COVID-19 pandemic affected all stocks regardless of company performance.

  • Characteristics: Includes overall market volatility, such as economic downturns impacting multiple sectors simultaneously.

Non-Systematic Risk (Unsystematic Risk)

  • Definition: Diversifiable risk; specific to individual investments.

  • Explanation: Can be mitigated through diversification across various companies and sectors.

Systematic Risk Details

Market Risk

  • Definition: Refers to the risk of losses due to overall market declines.

  • Example: A dip in stock prices across all sectors leads to losses regardless of individual stock performance.

Beta

  • Definition: A measure of a stock's volatility in relation to the market.

  • Beta Values:

    • Beta of 1: Indicates movement with the market (e.g., S&P 500).

    • Beta of 0.5: Indicates half the market movement.

    • Beta of 0: No movement.

    • Beta of 1.5: For every 10% market increase, the stock would increase 15% (10% x 1.5).

    • Negative Beta: Indicates inverse relationships with market movements.

  • Use of Beta: Helps investors understand expected volatility and risk exposure.

Interest Rate Risk

  • Definition: Risk related to changes in interest rates affecting fixed-income securities (like bonds).

  • Explanation: If interest rates rise, the attractiveness of existing bonds drops, leading to decreased bond prices.

  • Examples of Fixed Income Instruments Affected:

    • Bonds

    • Preferred Stocks

    • Collateralized Mortgage Obligations (CMOs)

  • Diversification strategies may reduce, but not eliminate interest rate risk.

Inflation Risk (Purchasing Power Risk)

  • Definition: The risk that inflation erodes the purchasing power of money over time.

  • Explanation: Fixed-income instruments (like bonds and annuities) may pay the same amount, but their value diminishes as prices rise.

Event Risk

  • Definition: Potentially negative impact from unforeseen events (e.g., natural disasters, terrorism).

  • Example: Economic downturns caused by events, such as the pandemic in March 2020.

Nonsystematic Risk Details

Alpha

  • Definition: Measure of a portfolio or stock’s performance relative to the expected return based on market movements.

  • Calculation: If expected return is based on beta, the actual return determines the alpha (positive if above expected, negative if below).

Business Risk

  • Definition: Risk associated with the specific business operations and management of a company.

  • Example: Investing solely in one company (e.g., Tesla) increases potential losses if that company's performance declines.

Regulatory Risk

  • Definition: Risk stemming from changes in regulations or not receiving necessary approvals.

  • Example: Pharmaceutical companies relying on FDA approvals for new drugs.

Legislative Risk

  • Definition: The risk involved if new laws negatively impact business sectors.

  • Example: Changes to tax codes affecting municipal bonds (munis) and their attractiveness.

Political Risk

  • Definition: Risk related to instability or changes in the political environment in a country.

  • Example: Investment loss due to nationalization in countries with unstable governments.

Liquidity Risk

  • Definition: The risk of being unable to sell an asset at a fair price in a timely manner.

  • Examples: Limited market for over-the-counter stocks or private placements.

  • Comparison: Common stocks and mutual funds tend to be more liquid compared to hedge funds or direct real estate investments.

Opportunity Risk (Opportunity Cost)

  • Definition: Cost of missing out on potential gains by choosing one investment over another.

  • Example: Choosing to invest in IBM instead of Tesla and missing the higher returns.

Reinvestment Risk

  • Definition: Risk of having to reinvest cash flows from an investment at lower interest rates.

  • Example: Receiving coupon payments during a period of declining interest rates.

Currency Risk

  • Definition: Involves the risk of investments in foreign currencies due to exchange rate fluctuations.

  • Implication: Currency values change relative to the US dollar, affecting returns on foreign investments.

Capital Risk

  • Definition: The risk of losing all or part of an investment.

  • Solution: Diversification can help mitigate capital risk.

Credit Risk

  • Definition: The risk that a bond issuer may default on payments.

  • Example: Bonds, municipal bonds, or other forms of debt carry intrinsic credit risk due to reliance on issuer solvency.

Call Risk

  • Definition: Issuers of bonds may choose to buy back bonds before maturity when interest rates fall.

  • Implication: This forces investors to reinvest at lower rates, similar to reinvestment risk.

Prepayment Risk

  • Definition: A specific risk associated with mortgage-backed securities where homeowners may refinance, leading to early repayment.

  • Example: Homeowners paying off loans when interest rates fall, affecting investors expecting stable monthly income.

Portfolio Strategies

Buy and Hold Strategy

  • Definition: Investing with the intention of holding for a long duration, minimizing transaction costs and taxes.

  • Risk: Opportunity risk if poor investment choices are made initially.

Portfolio Rebalancing

  • Definition: Adjusting the portfolio to maintain desired asset allocation levels after market fluctuations.

  • Frequency: Conducting rebalancing quarterly, annually, or as needed to manage risks effectively.

  • Types: Strategic vs. Tactical rebalancing.

    • Strategic: Long-term goals with occasional adjustments when allocations are skewed.

    • Tactical: Adjusting allocations based on market conditions and trends.

Indexing

  • Definition: Matching a portfolio to a specific market index, without trying to time the market.

  • Strategy: Passive management strategy aimed at mimicking the performance of an index (e.g., S&P 500, Russell 2000).

Active Strategies

  • Definition: Strategies focused on beating the market returns through active management decisions.

  • Method: Sector rotation based on economic cycles and sector performance.

  • Risk: Increased transaction costs and potential tax implications.

Dollar Cost Averaging

  • Definition: Investing a fixed amount at regular intervals to mitigate the effects of market timing.

  • Benefit: Consistent investment in varying market conditions averages out purchase prices over time.

Hedging Strategies

  • Definition: Protecting against potential losses using various financial instruments, such as options or futures.

  • Types:

    • Index Options: Buying puts for overall market protection.

    • Foreign Currency Options: Exporters and importers use FX options for hedging exchange rate risks.

    • Rule: Exporters buy put options; importers buy call options.

  • Note: There are no options available on the US dollar.

Conclusion

  • Summary of systematic and unsystematic risks and their implications on investment choices.

  • Encouragement: Importance of understanding and applying these risks in preparation for the SIE exam.

Finale Remarks

  • Emphasis on good practices in investing, risk management, and continuous learning in finance.