Series 7

Risk and Tax Considerations - Investment Risk (Part 1 of 2)


Inflationary Risk

Refers to the uncertainty of cash flows from a particular investment as a result of rising prices. It does not refer to the risk of inflation itself. The cost of living tends to go up; that is not a risk but a virtual certainty. The question here is, "What effect could inflation have on a particular investment?"

If you are looking at shares in a company that makes heart medication, the answer will be "virtually none". If the company has to pay more for the raw materials to make its pills, it will pay that additional cost and then pass on the expense to consumers, who will simply scale back on other purchases to buy the medicine that keeps them healthy. On the other hand, if a company that owns a chain of steak houses has to raise the prices on its menu because of inflation, consumers may go to less expensive restaurants, order less expensive entrees or simply eat at home more often. In these two examples, the pharmaceutical company's stock does not have substantial inflationary risk because its cash flows are likely to keep pace with inflation. Shares in the restaurant chain, however, do have inflationary risk because the chain's cash flows are likely to be negatively affected by inflation.

Capital Risk
The risk that an investor may lose all or part of the principal invested. This risk has more to do with the type of investment - stocks, bonds, and options - than with a particular recommendation within that type.

Bonds issued by or guaranteed by the U.S. federal government have virtually no capital risk; if Uncle Sam defaulted on his bonds, we would all have bigger things to worry about than our investments. All stocks - or any equity instrument - carry some capital risk. Corporate bonds carry less than stocks, municipal bonds less still. Capital risk related to options tends to follow the risk of the option's underlying assets.

Timing Risk
The uncertainty that the investor will have to sell the investment for less than anticipated due to market timing. This risk can be ascribed to virtually any investment that trades publicly, although it does not apply to such conservative instruments as certificates of deposit. Remember, it is the risk that the investment will not pay out as much as expected. If you expect an investment to appreciate 20% and it only appreciates 15% - then spikes up the day after you sell it - that is timing risk too.

Interest Rate Risk
Similar to inflationary risk because it also looks at an investment's sensitivity to an economic factor beyond the control of either the issuing firm or the investor. Interest is the cost of money. When the cost of everything else goes up, the cost of money is likely to go up as well. When it does, the market value of bonds that were issued during times of lower interest rates will drop.

Suppose a 10-year bond was issued with a 5% interest rate in 2015. Suddenly, in 2016, interest rates rise sharply and anyone who wants to raise money in the bond market starts issuing bonds at 8%. The market price of the 5% bond will drop until it provides the same return as a new 8% bond. The same logic holds true for utility company stocks, which typically offer a high dividend but are not known for dramatic share price growth. A $100 stock that guarantees a $5 annual dividend is not substantively different from a bond offering 5% interest.

Market/Systematic Risk
The chance that the whole economy goes sour. This risk underlies all other investment risks. If there is inflation, you can invest in securities in inflation-resistant economic sectors. If interest rates are high, you can sell your utility stocks and move into newly issued bonds. However, if the entire economy underperforms, then the best you can do is attempt to find investments that will weather the storm better than the broader market. Popular examples are defensive industry stocks, for example, or bearish options strategies.

Look Out!
Unsystematic, or company-specific risk, affects only a small number of assets and can be eliminated through diversification.
 


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