Systematic Risk

Types of Risk
Saving money and investing money are not the same thing. In a savings account, the only risk is that your money will lose purchasing power. When you invest, on the other hand, you take the risk that you could lose your money. This is called capital risk. If you buy U.S. Treasury Bonds, you eliminate capital risk, but if you buy corporate bonds or common stock, you face the risk of losing some or all your invested capital.

Investing in common stock presents significantly more capital risk than investing in corporate bonds, which is why the potential reward is also higher on common stock.

The prospectus for a growth fund typically declares that its investment goal is "growth of capital," and then goes on to say that "dividend income, if any, will be incidental to this goal." In other words, the fund invests in growth stocks, but some companies expected to grow will also pay dividends, and this fund does not mind cashing their checks. It's just that the dividends have nothing to do with the fund's reasons for investing in the stock. It's the growth or capital appreciation they're after.

Systematic Risk
it is called "Important risks" such as:
Stock market risk, or the risk that the price of securities held by the Fund will fall due to various conditions or circumstances which may be unpredictable.

1. Market RiskMarket risk is a type of systematic risk, which means it affects securities across the board, as opposed to an unsystematic risk, which affects only particular stocks or bonds or industry sectors. Market risk is the risk that an investment will lose value due to an overall market decline. As the prospectus says, the circumstances may be unpredictable. For example, no one can predict the next war or credit crisis, but when events like that take place, they can have a devastating effect on the overall market.
Whether they panic because of war, weather, or whatever, the fact is when investors panic, stock prices plummet. We might think of stock market risk as the fact that even though the company might be doing well, the stock investment in that company could drop because the overall stock market panics.

Unfortunately, diversification does not help. If the overall market is going down, it doesn't matter how many different stocks we own; they're all going down. That's why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall market; therefore, investors use options, futures, and Exchange-Traded Funds to bet that the overall market will drop.

Beta is a risk measurement of how volatile an individual stock is compared to the overall market. If MSFT has a beta of .8, it goes up and down only 80% as much as the overall market as measured by the S&P 500. If the S&P 500 rises 10%, MSFT goes up only 8%, and when the S&P 500 drops 10%, MSFT drops only 8%. If SBUX has a beta of 1.3, it is 30% more volatile than the overall market—or 1.3 times as volatile. If the S&P drops 4%, SBUX drops 5.2%, and so on.
A stock with a beta of 1 is in line with the overall market in terms of volatility. A stock with a beta of less than 1 is less volatile than the overall stock market. But, stocks in general are volatile, so that investment could scare off many investors.

Natural Event Risk
Natural event risk refers to the fact that a tsunami, earthquake, or hurricane could have a devastating effect on a country's economy, and possibly the economy of an en¬tire area such as Europe or Southeast Asia.

Unfortunately, natural event risk does not fit neatly in the systematic or unsystematic risk category. While a tsunami would have a negative impact on markets overall, there are many weather-related events that hit certain sectors or issuers only, making it an unsystematic risk. For example, food and energy producers are affected by weather events that might not impact other industries. A Florida frost impacts orange juice, unlike a tsunami, which impacts entire regions of the globe.
And, there are some industries that do better after natural disasters such as a flood or hurricane: mold remediation, construction, disaster recovery, etc.

Interest Rate Risk
Interest rate risk is the risk that rates will rise, pushing down the market prices of bonds. The longer the term on the bond, the more volatile its price, too. When rates go up, all bond prices fall, but the long-term bonds suffer the most. And, when rates go down, all bond prices rise, but the long-term bonds go up the most.

So, a 30-year government bond has no default risk, but carries more interest rate risk than a 10-year corporate bond. The reason we see short-term and intermediate-term bond funds is because many investors want to reduce interest rate risk. Maybe they have a shorter time horizon and will need this money in just a few years—they can't risk a big drop in market value due to a sudden rise in interest rates. They will prob¬ably sacrifice the higher yield offered by a long-term bond fund, but they will sleep better knowing that rising rates won't be as devastating to short-term bonds.

In a bond fund prospectus, we see that the important risks include:
Risk that the value of the securities the Fund holds will fall as a result of changes in interest rates.
Interest rate risk. Rates up, price down and it's more severe the longer the term to maturity.

Purchasing Power Risk
Purchasing power risk is sometimes called inflation risk and even constant dollar risk. If inflation erodes the purchasing power of money, an investor's fixed return can't buy what it used to. Fixed-income investments carry purchasing power or inflation risk, which is why investors often try to beat inflation by investing in common stock.

The ride might be a wild one in the stock market, but the reward is that we should be able to grow faster than the rate of inflation, whereas a fixed-income payment is fixed. Retirees living solely on fixed incomes are more susceptible to inflation or purchasing power risk than people in the workforce, since salaries tend to rise with inflation. The longer the retiree has to live on a fixed income, the more susceptible she is to inflation risk.

Unfortunately, common stock is often too volatile for investors with shorter time horizons and high needs for liquidity. The solution is often to put the majority of a retiree's money into short-term bonds and money market instruments with a small percentage in large-cap stock, equity income, or growth & income funds. That way, the dependable income from the short-term debt securities will cover the living expenses, while the smaller piece devoted to conservative stock investments will likely provide some protection of purchasing power. Not to mention that blue chip stocks almost by definition pay dividends, and dividends tend to increase over time. So, putting a reasonable percentage of a retiree's money into blue chip stocks is not necessarily risky, as might have been thought in the past.

Call Risk
A bond fund prospectus typically warns of call risk, or "the risk that a bond might be called during a period of declining interest rates." Most municipal and corporate bonds are callable, meaning that when interest rates drop, corporate and municipal bond issuers will borrow new money at today's lower rate and use it to pay off the current bondholders much sooner than they expected.

The problems for the current bondholders are that, first, the bond price stops rising in the secondary market once everyone knows the exact call price to be received. And, second, what do they do with the money they just received from the issuer? Reinvest it, right? And, where are interest rates now? Down so they probably take the proceeds from a 9% bond and turn it into a 6% payment going forward. That means on a million dollars of principal they used to get $90,000 per year; now they can look forward to just $60,000 in interest income. Couldn't we protect ourselves by buying non-callable bonds? Sure, but they'll offer lower rates than what they pay on callable bonds. As they say, there is no free lunch.

Prepayment and Extension Risk
Prepayment risk is the form of call risk that comes with owning a mortgage-backed security. A homeowner with a mortgage will typically take advantage of a sudden drop in interest rates by refinancing. Therefore, if an investor holds mortgage-backed securities like those issued or guaranteed by GNMA, FNMA, or FHLMC (Ginnie, Fannie, Freddie), that investor will take a hit if interest rates drop suddenly and all the principal is returned sooner than expected. This is called prepayment risk.
When the investor receives the principal sooner than expected, she typically ends up reinvesting it into similar mortgage-backed securities and receiving a lower rate of interest going forward, while the homeowners in the pool of mortgages, on the other hand, are enjoying paying lower interest rates going forward.
On the other hand, if interest rates rise, homeowners will take longer than expected to pay off the mortgages. This scenario is called extension risk. Notice that most debt securities have stated maturities, while an investment in most mortgage-backed securities comes with an estimate only. Sort of like bonds without maturity dates.

Since GNMA (Ginnie Mae) securities are guaranteed by the U.S. Treasury, their main risk is prepayment—or extension—risk. An investment in FNMA or FHLMC securities have that plus credit/default risk.

Reinvestment Risk
If bond investors don't spend the interest payments to meet living expenses, they reinvest them into new bonds. What kind of yields will debt securities offer when they reinvest the coupon payments? No one knows, which is why it's a risk, called reinvestment risk. It's frustrating to take a 6% interest payment and reinvest it at 3%, but it does happen.

To avoid reinvestment risk, some investors buy a debt security that pays nothing to reinvest along the way: zero coupons, i.e., Treasury STRIPS. A zero-coupon bond returns a higher principal amount to the investor rather than paying any regular interest over the term to maturity.

Even though bond investing is less risky than stock investing, notice how bondholders can get hurt many ways. If it's a corporate bond, they could end up with a default. Whether it's a corporate, municipal, or a U.S. Treasury bond, when rates go up, the price of the bond drops. If rates go down, callable bonds are called, and the party's over, and with non-callable bonds they must reinvest the interest checks every six months at a lower rate going forward. And, even if none of the above happens, inflation could inch its way up, making the coupon payments less valuable.

Political Risk
Political risk is part of the package with investments into emerging markets. An emerging market is a country or region where the financial markets are immature and unpredictable. They're not fully developed, a little awkward, a bit volatile, basically like teenagers bright future, but some days you really aren't sure if they're going to make it. If you own stocks and bonds in companies operating and trading in undeveloped economies, what happens if the Chinese government gets tired of capitalism and seizes the companies whose shares you used to own? Total loss. Or maybe the transition from communism to "capitalism" doesn't go so well, and suddenly the whole country is shut down with riots in the streets and government tanks rolling in. When this type of thing happens, emerging market investments are affected.
Investing in emerging markets is high-risk, but it also protects U.S. investors against a down year for the domestic stock market. Even if the S&P 500 drops, companies in Brazil or China may do well and take their related stock markets up with them.

Currency Exchange Risk
Since most countries use a different currency from the American dollar, currency exchange risk is also part of the package when investing in foreign markets, emerging or otherwise. The value of the American dollar relative to foreign currencies, then, is a risk to both international and emerging markets investors. So, even if it's a developed market, such as Japan, if we are investing internationally into Japanese stocks, the value of the yen versus the dollar presents foreign exchange or currency risk. If we are investing in China, we have that risk, plus the political risk of investing in companies operating in an immature capitalist system likely to suffer many set¬backs before all the kinks are worked out.


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