Systematic Risk

• Systematic risks are those that affect the value of all securities and cannot be avoided through diversification, including:
• Market Risk
  • Risk inherent in all securities due to market fluctuation
• Interest-rate Risk
  • Risk that the value of a mixed income investment (bond) will decline due to a rise in interest rates
• Inflation Risk
  • Risk that an asset or the purchasing power of income may decline over time, due to the shrinking value of the country’s currency
    • To find a bond’s real interest rate, the formula is:
      • Nominal Yield – Inflation Rate
• Event Risk
  • Risk that a significant event will cause a substantial decline in the market

Measuring Systematic Risk

• Beta measures the volatility of an asset (typically an equity) relative to the entire market
  • A stock’s beta is compared to the beta of the S&P 500, which is always 1.00
  • If a stock’s beta is more than 1, it’s expected to outperform when the market is up and underperform when the market is down
  • If a stock’s beta is less than 1, it’s expected to underperform when the market is up and outperform when the market is down

The Impact of Interest-Rate Risk (systematic risk)

• Fixed income investors (bondholders) are most affected by interest-rate risk
  • Rising interest rates result in falling bond prices
    • Cannot be avoided by diversifying
    • Long-term debt is more vulnerable than short-term debt
    • Duration is used to measure the change in a bond’s price based on a given change in interest rates
      • Measured in terms of years; the higher the duration, the higher the risk
  • Equities of highly leveraged companies (e.g., utilities) and preferred stocks are susceptible to interest-rate risk 

The Impact of Inflation Risk

• What is Inflation?
  • Inflation occurs when there’s a continual increase in consumer prices or decline in a currency’s purchasing power, caused by an increase of currency and credit beyond the availability of goods and services
• Inflation risk, also referred to as purchasing power risk, is most detrimental to investments that offer fixed payments
  • Inflation leads to increasing interest rates, thereby causing fixed payments securities to fall in value
  • Rising prices diminishes the purchasing power of these same securities
  • Common stock, variable annuities, real estate, and precious metals tend to perform better during times of inflation

Matching

• Rising interest rates
  • Purchasing power is diminished
• Falling interest rates
  • Bond prices are increasing
• Real interest rates
  • Factors in the rate of inflation when determining return 
• High beta
  • Investment outperforms a rising market and underperforms a falling market
• Low beta
  • Investment underperforms a rising market and outperforms a falling market

Unsystematic Risk

• These risks are unique to a specific security and can be managed through diversification
• Business Risk
  • Risk that a company may perform poorly causing a decline in the value of the stock
• Regulatory Risk
  • Risk that new regulations may have a negative impact on an investment’s value 
• Political Risk
  • Risk that political event outside of the US could adversely affect the domestic markets
• Liquidity Risk
  • Stemming from a lack of marketability, this is risk that an investment cannot be bought or sold quickly enough to prevent or minimize a loss

Additional Risks

• Capital Risk
  • Risk of investors losing their invested capital (lower for bonds)
• Credit Risk
  • Risk that a bond may not repay its obligation
  • Treasuries have no credit risk pretty much
• Currency Risk
  • Risk of loss when converting an investment that’s made in a foreign currency into US dollars
• Legislative Risk
  • Risk that new laws may have a negative impact on an investment’s value (e.g., tax code changes)
• Opportunity Risk
  • Risk of passing on the opportunity of making a higher return on another investment 
• Reinvestment Risk
  • Risk that interest rates will fall and semiannual coupons will be invested at a lower rate
    • The risk that you won’t be able to reinvest into the coupon at the YTM
    • Zero-coupon bonds eliminate reinvestment risk
• Prepayment Risk
  • Risk that mortgages will be paid off early due to lower interestrates, resulting in reinvestment in lower yielding investments
    • Refinancing your mortgage at a lower rate
    • MBS get prepaid quicker when interest rates fall

Determine which type of risk describes it

• The cost of importing goods is increasing
  • Currency risk
• Mortgage-backed securities are maturing early
  • Prepayment risk
• New leadership assumes control in a foreign country
  • Political risk
• Congress has made changes to the tax code
  • Legislative risk 

Asset Allocation

• Asset allocation focuses on a portfolio constructed of various asset classes
• An optimal portfolio (one producing the greatest return for a given amount of risk) is based on a client’s goals, expected return and risk tolerance

Passive (Strategic) Asset Allocation

• Assumes that markets are efficient and creating an optimal portfolio requires allocating assets based on a client’s risk tolerance and investment objectives
• Buy-and-Hold (do nothing)
  • Minimizes transactions costs and tax consequences
  • However, the asset mix of the portfolio may drift over time (if equities or bonds grow/fall more than the other)
• Indexing
  • Maintaining investments in companies that are part of major stock (or bond) indexes
  • Infrequent rebalancing
• Systematic Rebalancing 
  • Involves buying and selling assets on a periodic basis
  • More frequent rebalancing keeps the portfolio closer to its strategic allocation
  • May result in higher transaction costs as well as tax consequences 

Tactical (Active) Asset Allocation

• Assumes that markets are inefficient
• Involves altering the asset mix in anticipation of changing economic conditions/events (Market timing)
  • Sector Rotation is one example
    • Money is moved from one industry or sector to another in an attempt to beat the market
    • A portfolio manager who employs a sector rotation strategy will try to anticipate the next turn in the business cycle and shift assets into the sectors that will benefit 

Dollar Cost Averaging

• With dollar cost averaging,the good news is that:
  • When share prices are up, the previously purchased shares are worth more
  • When share prices are down, the investor will be able to purchase more shares at a lower price
• Involves making the same periodic investment regardless of share price over a fixed period of time
  • Investors will purchase more shares when price is low and fewer shares when price is high
• Advantage
  • Results in the average cost of shares being less than their average price 
• Disadvantage

Hedging Risk

• Options are popular investments to use as a hedge (protection):
  • Equity options can protect individual stocks
  • Index options can protect an entire portfolio
  • Currency options can protect against exchange-rate risk
    • To hedge the US dollar, investors must take the opposite position on the currency option
• If an investor anticipates an increase, in the underlying asset’s value, but fears a decrease, he should
  • Buy a PUT
• If an investor anticipates an decrease, in the underlying asset’s value, but fears a increase, he should
  • Buy a CALL