Securities risk analysisInvestors face many risks (and hopefully many rewards) when investing in the market. You need to understand the risks because not only can this knowledge make you sound like a genius, but it can also help you score higher on the Series 7:
- Market (systematic) risk: The risk of a security declining due to negative market conditions. All securities have market risk.
- Call risk: The risk that a corporation could call its callable bonds at a time that's not advantageous to investors. Corporations will more likely call their bonds when interest rates decrease.
- Business (nonsystematic) risk: The risk of a corporation failing to perform up to expectations.
- Credit risk: The risk that the principal and interest aren’t paid on time. Moody’s, Standard & Poor’s, and Fitch are the main bond-rating companies.
- Liquidity (marketability) risk: The risk that the security is not easily traded. Long-term bonds and limited partnerships have more liquidity risk.
- Interest (money rate) risk: The risk of bond prices declining with increasing interest rates. (When interest rates increase, outstanding bond prices decrease.) All bonds (even zero-coupon bonds) are subject to interest risk.
- Reinvestment risk: The risk that interest and dividends received will have to be reinvested at a lower rate of return. Zero coupon bonds, T-bills, T-STRIPS, and so on have no reinvestment risk because they don’t receive interest payments.
- Purchasing power (inflation) risk: The risk that the return on the investment is less than the inflation rate. Long-term bonds and fixed annuities have high inflation risk. To avoid inflation risk, investors should buy stocks and variable annuities.
- Capital risk: The risk of losing all money invested (for options and warrants). Because options and warrants have expiration dates, purchasers may lose all money invested at expiration. To reduce capital risk, investors should buy investment-grade bonds.
- Regulatory (legislative) risk: The risk that law changes will affect the market.
- Currency risk: The risk that an investment’s value will be affected by a change in currency exchange rates. Investors who have international investments are the ones most affected by currency risk.
- Nonsystematic risk: A risk that is unique to a certain company or a certain industry. To avoid nonsystematic risk, investors should have a diversified portfolio.
- Political (legislative) risk: The risk that the value of a security could suffer due to instability or political changes in a country (for example, the nationalization of corporations).
- Prepayment risk: The type of risk mostly associated with real-estate investments such as CMOs. CMOs and other mortgage-backed securities have an average expected life, but if mortgage interest rates decrease, more investors will refinance and the bonds will be called earlier than expected.
- Timing risk: The risk of an investor buying or selling a security at the wrong time, thus failing to maximize profits.
On the Series 7 exam, to determine the best investment for a customer, pay close attention to the investor's risk tolerance, financial considerations, non-financial considerations, risk(s) mentioned, and so on. If the question isn’t specific about the type of risk, use strategic asset allocation to determine the best answer.
Mitigation of risk with diversificationCertainly, all investments have a certain degree of risk. Younger investors, sophisticated investors, and wealthy investors can all afford to take more risk than the average investor. However, when you are talking to your clients, you should examine their portfolio and help them make decisions that will help them mitigate their risk. You should help them invest in securities that aren't too volatile for their situation and make them aware of the potential tax ramifications of certain investments.
You’ve probably heard the expression, “Don’t put all your eggs in one basket.” Well, the same holds true for investing. Suppose for instance that one of your customers has everything invested in DIMP Corporation common stock. All of a sudden, DIMP Corporation loses a big contract or is being investigated. Your customer could be wiped out. However, if your customer had a diversified portfolio, DIMP Corporation would likely only be a small part of her investments and she wouldn’t be ruined. This is the reason that having a diversified portfolio is so important.
You are responsible for making sure that your clients understand the importance of having a diversified portfolio to minimize risk. Investors with securities concentration are at risk of major losses due to having a large portion of their holdings in a particular market segment (for example, automotive stocks) or investment class.There are many ways to diversify:
- Geographical: Investing in securities in different parts of the country or world.
- Buying bonds with different maturity dates: Buying a mixture of short-term, intermediate-term, and long-term debt securities.
- Buying bonds with different credit ratings: You may purchase high-yield bonds (ones with a low credit rating) with highly rated bonds with lower returns so that you get a mixture of high returns with the safety of the highly rated bonds.
- Investing in stocks from different sectors: Often, certain sectors of the market perform better than others. By spreading your investments out among these different sectors, you can minimize your risk and hopefully make a profit if one or more sector happens to be performing well. The sectors include financials, utilities, energy, healthcare, industrials, technology, and so on.
- Type of investment: Investing in a mixture of different types of stocks, bonds, DPPs, real estate, options, and so on.
There are certainly many more ways to diversify a portfolio than the ones listed previously — use your imagination. In addition, they aren’t mutually exclusive. Remember that mutual funds (packaged securities) provide a certain amount of diversification within an individual stock. This is why smaller investors who may not be able to afford to diversify their portfolio are ideal candidates for mutual funds.