By Majda Muhic, Fall 2016 Student Intern
On June 24, 2016, in light of the British vote to leave the European Union, FINRA re-issued its Investor Alert Market Risks: What You Don’t Know Can Hurt You. The alert focuses on the elusive notion of market risk: the risk that overall shifts in the market may devalue your investment portfolio. While market risk factors may seem far removed from your doorstep, or your bank account, their effects are palpable and may be devastating. Just think back to the recent recession.
Unlike business, or “non-systematic” risks associated with a particular product, company or industry, market risks are systemic – and utterly beyond your control. The FINRA alert outlines the main types of market risks and provides some points on how to manage the unmanageable.
Rainbow of Risks
The specter of inflation may be the most familiar yet elusive risk of all. Inflation is the general increase in prices and accompanying decrease in the purchasing power of your money: yesterday you could buy four popsicles for a dollar and today only one. This decrease in cash worth inevitably decreases the worth of your investments. It is also entirely beyond your control.
This so-called Inflation Risk is often referred to as Purchasing Power Risk and is closely related to another type of risk: Interest Rate Risk. When money buys less, lenders increase interest rates to compensate for this loss of purchasing power. Changes in interest rates, in turn, directly affect the value of your bonds. More precisely, rising interest rates directly devalue your bonds. A bond issued at a certain interest rate is worth less if the interest rate goes up; conversely, if interest rates decline, the value of your bond increases. You feel this abstract domino effect of purchasing power decline and interest rate increase in the diminishing value of your actual investments.
If you invest in international securities, you may also face Currency Risk: the effect of changing exchange rates on the value of your investments. Changes in exchange rates may, in fact, lead to financial loss. Even if the actual value of your foreign stock stays the same, your initial investment of $1000 may be worth far less once converted back from the local currency. In today’s global market, the Currency Risk affects large numbers and types of investments.
How fast, or slow, you can sell or buy an investment is referred to as the investment’s liquidity. Liquidity Risk refers to the risk of not being able to do so fast enough to keep up with an investment’s actual worth. The value of your investment may plummet before you find a buyer for it.
The effect of larger social and political events on the market is referred to as Sociopolitical Risk. While the events may be actual or merely anticipated, the responses of other investors to the events are real, as are their effects on your wallet. Earthquakes and elections or a terrorist threat – as remote as they appear from your investment portfolio – may significantly affect its value. For more on how this election may affect your wallet, see Time’s article How the Election will Really Affect your Investments.
Similarly, you may feel the effect of apparently remote socio-political shifts in foreign countries on your foreign investments. This is referred to as Country Risk. The market uncertainty and volatility that followed Britain’s decision to leave the EU is a case in point. Finally, if your investment creates a legal problem, particularly in a foreign country, you may not have the means to resolve it: appropriate legal measures may not exit, or you may simply not have the money to do it. This is referred to as Legal Remedies Risk.
Managing the Unmanageable
So, how can you protect yourself from these nebulous forces over which you have zero control? While absolute protection is impossible, you can take small yet crucial steps to minimize them.
First, follow the basic investment risk management mantra: diversify. Do not put all of your eggs in one basket.
Second, do your research. Get, and stay, informed. Stay in tune with global economic trends and developments; learn more about the industry you’re considering investing in; research the social, political, economic, and legal context of your foreign investments. FINRA’s Smart Investing Series can help you make informed investment decisions.
The price of a Popsicle, the strength of the British Pound and Donald Trump’s election campaign invariably affect your wallet. Stay informed. What You Don’t Know Can Hurt You.