Systematic risk, or market risk, is the risk of the decline in value of securities based on factors that affect the overall economy or securities markets. This type of risk affects all companies: it is unrelated to the firm’s size, financial condition, management team, or capital structure. Common systematic risks include:
- Interest rate risk – the risk that the value of security will fall due to changes in interest rates. Bonds and preferred stock are examples of securities that face interest rate risk
- Inflation risk – the risk that the returns produced by an investment will generate reduced purchasing power as prices increase due to inflation. Securities that produce a fixed income stream, such as bonds and preferred stock typically carry higher inflation risk. Equities and real estate investments are potential hedges against inflation
- Liquidity risk – the risk that a security cannot be sold at a price reflecting its true underlying value. Small-cap stocks and OTC securities often face greater liquidity risk than more heavily traded securities
Investors can guard against systemic risk by creating a portfolio of investments that react differently in a given economic scenarios. For example, an investor may diversify across both stocks and bonds:
- In inflationary environments the value of the equity securities will increase on the whole while the bonds may decline in price.
- In deflationary periods, with falling interest rates, the bonds may perform strongly while stocks as an asset class may not.
Registered reps need to demonstrate an understanding of the risks investors face when purchasing securities, and how, if at all, those risks can be reduced or minimized. Reps should be prepared to explain to clients what systematic risk, or market risk, is and how it is difficult to reduce or eliminate, and how it could impact a client’s portfolio.
Series 7, Series 24, Series 63, Series 65, Series 66, Series 79