Market Risk

Market risk sits among several types of risk. Corporate decisions, such as whether to expand into a new area of business or merge with another company, can affect the value of an investment (business risk). If an investor owns an international investment, events within that country can affect the investment (political risk and currency risk, to name two). How easy or hard it is to cash out of an investment when an investor needs to is called liquidity risk. Generally speaking, the more financial eggs an investor has in one basket, say all the investor's money in a single stock, the greater the risk the investor takes (concentration risk).

Systemic risk is risk affecting the economy as a whole. Non-systemic risk consists of risks that affect a small part of the economy, or even a single company.

Reading the Words: Volatility, Beta, Diversification and Hedging

Anyone who follows the stock market knows that some days market indexes and stock prices move up and other days they move down. This is called volatility. The more dramatic the swings, the higher the level of volatility, and potential risk. When a security, a commodity or an index fluctuates wildly in a short period of time, it is experiencing volatility.

When it comes to individual stocks, a common measure of volatility relative to the broader market is known as the stock's beta. Beta measures how a stock moves relative to the market movement, not the total volatility of a stock. A stock can have high volatility but a low beta if its movements do not correlate with market moves. Beta compares the movements of an individual security against those of a benchmark index, which is assigned a beta of 1.

Diversification is the practice of spreading money among different investments to reduce risk. Diversification is a strategy that can be neatly summed up as "Don't put all your eggs in one basket." A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. One way to diversify is to allocate investments among different kinds of assets. Factors or market conditions that may cause one asset class to perform poorly may improve returns for another asset class.

Hedging is buying a security to offset a potential loss on another investment. A long put option added to long stock insures the stock's value. A collar writes a call and buys a put with the same expiration as a means to hedge a long position in the underlying stock.

Words for a Falling Market

When a stock or bond index, or a commodity's price, falls and keeps falling, it is considered to be in a bear market. Generally, a decline of 20 percent or more in a broad market index is said to meet the threshold of a bear market. The term is often used in contrast with bull market, which refers to a large increase in prices.

A correction is when stocks, bonds, commodities or indices reverse course by at least 10 percent before resuming their previous upward or downward trend. Though a correction can technically describe either a 10 percent increase or decrease, usually it is used in reference to a drop in prices.

A sell-off describes what happens when, following a major decline in the prices of stocks, bonds or other securities, market participants collectively sell large quantities of those falling securities as they seek to prevent losses from future price declines.

How Market Risk Shows Up in Stocks

The volatility of stocks makes them a very risky investment in the short term. Based on historical data, holding a broad portfolio of stocks over an extended period of time significantly reduces the chance of losing principal. However, the historical data should not mislead investors into thinking that there is no risk in investing in stocks over a long period of time. Investors should also consider how realistic it will be for them to ride out the ups and downs of the market over the long term. That is why stocks are always risky investments, even over the long term. They do not get safer the longer they are held.

Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, an investor will reduce the risk of losing money, and the portfolio's overall investment returns will have a smoother ride.

Managing Market Risk

An investor cannot eliminate investment risk. But two basic investment strategies, asset allocation and diversification, can help manage both systemic risk and non-systemic risk. Hedging and insurance products can provide additional ways to manage risk.

Risk tolerance is the ability and willingness to lose some or all of the original investment in exchange for potentially greater returns. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks. An investor with a high risk tolerance is willing to risk losing money to get potentially higher returns. An investor with a low risk tolerance favors investments that seek to maintain their original investment.

Diversification is one way to manage volatility, and the anxiety that can come with it.

People invest in various asset classes in the hope that if one is losing money, the others make up for those losses. An investor is also better diversified by spreading investments within each asset class. That could mean holding a number of different stocks or bonds, and investing in different industry sectors, such as consumer goods, health care, and technology. That way, if one investment or sector is doing poorly, it may be offset with other holdings that are doing well.

A mutual fund or exchange-traded fund will not necessarily provide diversification, especially if it is narrowly focused, such as on one industry sector. An investor who invests in narrowly focused funds may need to invest in several to be diversified.

Trading Safeguards in a Severe Decline

The securities and futures exchanges have procedures for coordinated cross-market trading halts if a severe market price decline reaches levels that may exhaust market liquidity. These procedures, known as market-wide circuit breakers, may halt trading temporarily or, under extreme circumstances, close the markets before the normal close of the trading session.

Market-wide circuit breakers provide for cross-market trading halts during a severe market decline as measured by a single-day decrease in the S&P 500 Index. A cross-market trading halt can be triggered at three circuit breaker thresholds. A market decline that triggers a Level 3 circuit breaker, at any time during the trading day, will halt market-wide trading for the remainder of the trading day.

Market Risk in Company and Fund Disclosure

Item 305 of Regulation S-K, a Securities and Exchange Commission rule, requires registrants to provide quantitative and qualitative information about market risk. General Instruction 3 to the Item refers collectively to derivative financial instruments, other financial instruments, and derivative commodity instruments as market risk sensitive instruments. A Securities and Exchange Commission staff publication of questions and answers on the market risk disclosure rules describes the rules as addressing risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices, and other market changes that affect market risk sensitive instruments. Under Item 305(a)(1), registrants shall provide, in their reporting currency, quantitative information about market risk as of the end of the latest fiscal year, in accordance with one of three disclosure alternatives. Within both the trading and other than trading portfolios, separate quantitative information shall be presented, to the extent material, for each market risk exposure category, namely interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market risks, such as equity price risk.

The first alternative is tabular presentation of information related to market risk sensitive instruments, which shall include fair values of the market risk sensitive instruments and contract terms sufficient to determine future cash flows from those instruments, categorized by expected maturity dates. The second is sensitivity analysis disclosures that express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices over a selected period of time. The third is value at risk disclosures that express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments over a selected period of time, with a selected likelihood of occurrence, from changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices.

Under Item 305(b), to the extent material, a registrant describes its primary market risk exposures, how those exposures are managed, including the objectives, general strategies, and instruments, if any, used to manage those exposures, and changes in either the primary market risk exposures or how those exposures are managed, when compared to what was in effect during the most recently completed fiscal year and what is known or expected to be in effect in future reporting periods. Under Item 305(e), a smaller reporting company, as defined by Section 229.10(f)(1), is not required to provide the information required by the Item.

For mutual funds, Item 4(b)(1)(i) of Form N-1A directs the fund to summarize the principal risks of investing in the fund, including the risks to which the fund's portfolio as a whole is subject and the circumstances reasonably likely to affect adversely the fund's net asset value, yield, and total return. Unless the fund is a money market fund, the fund must disclose that loss of money is a risk of investing in the fund.

Market Risk and Recommendations

Rule 2111(a) of the Financial Industry Regulatory Authority, known as FINRA, provides that a member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation. Under Supplementary Material .02, a member or associated person cannot disclaim any responsibilities under the suitability rule. Under Supplementary Material .08, the rule does not apply to recommendations subject to SEA Rule 15l-1, the Securities Exchange Act rule known as Regulation Best Interest.

Regulation Best Interest provides that a broker, dealer, or natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities, including account recommendations, to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer. Under the care obligation, the broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with the recommendation, and to have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers. The same obligation requires a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer's investment profile and the potential risks, rewards, and costs associated with the recommendation, and that it does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer.

Market Risk on the Examination

The content outline for the Securities Industry Essentials examination lists investment risks under Topic 2.2 in Section 2, Understanding Products and Their Risks. Under that topic, Definition and Identification of Risk Types lists capital, credit, currency, inflationary/purchasing power, interest rate/reinvestment, liquidity, market/systematic, non-systematic, political, and prepayment. Strategies for Mitigation of Risk lists diversification, portfolio rebalancing, and hedging. Candidates should check the current outline before the examination.

Common Misunderstandings

Market risk can be eliminated. An investor cannot eliminate investment risk.

Holding stocks for a long time makes them safe. Stocks are always risky investments, even over the long term, and they do not get safer the longer they are held.

Volatility and beta are the same measure. Beta measures how a stock moves relative to the market movement, not the total volatility of a stock, and a stock can have high volatility but a low beta if its movements do not correlate with market moves.

Owning a fund guarantees diversification. A mutual fund or exchange-traded fund will not necessarily provide diversification, especially if it is narrowly focused.

Market risk is the only risk in an investment. Business risk, political risk, currency risk, liquidity risk and concentration risk are described separately from market risk.

Circuit breakers prevent market declines. Market-wide circuit breakers may halt trading temporarily or, under extreme circumstances, close the markets before the normal close of the trading session.

Only company-specific events cause an investment to lose value. An investment's value might rise or fall because of market conditions, and non-systemic risk is the term for risks that affect a small part of the economy, or even a single company.

Key Points

An investment's value might rise or fall because of market conditions, which is market risk.

All investments involve some degree of risk, and an investor cannot eliminate investment risk.

Beta measures how a stock moves relative to the market movement, not the total volatility of a stock, and a benchmark index is assigned a beta of 1.

Asset allocation and diversification can help manage both systemic risk and non-systemic risk, and hedging and insurance products can provide additional ways to manage risk.

Stocks do not get safer the longer they are held, even though holding a broad portfolio of stocks over an extended period significantly reduces the chance of losing principal.

Market-wide circuit breakers may halt trading temporarily or close the markets before the normal close of the trading session during a severe market decline.