Understanding "The Reality of Risk"

What Is the Difference between Business Risk and Market Risk?

The following section is based on different perspectives coming together for your consideration. Parts are based on the views of the securities industry, and others take in the perspective of the savings industries: banking, and insurance. Such an approach should bring about thoughts, and affect your perspective, which would be unachievable by presentation of a single viewpoint.

"Risks associated with investing in a particular product, company, or industry sector, can be called business risks. These risks are "non-systematic", they are related directly to a business, company, or industry sector. Systemic risks on the other hand, would be risks related to the trouble of an entire market place, an economy, which today, could very well be global in nature, a byproduct of the evolution of the interconnectivity of our global economy. What happens in one state or province can affect an entire country, continent, and global economies. We will be discussing both types of risks in this section.

The following risks are considered to be "non-systematic":

• Management risk or company risk encompasses a wide array of factors than can impact the value of a specific company. For example, the managers who run a company might make a bad business decision. As evident from media headlines, executives may become embroiled in a scandal, causing a drop in the value of the company's stocks or bonds. Alternatively, a key competitor might release a new product thought to be a better product or service than the company in question. Capitalism is thought to spur competition by its very nature. Hence, one company may displace another, with new fortunes being made, and others lost.
• Credit risk or default risk is the chance that a bond issuer will fail to make interest payments or will be able to pay back your principal (which loaned to the company, or municipality) when your bond matures.

Market risk, is also referred to as systematic risk, and involves factors that affect the overall economy and, hence, the securities markets. It is the risk that an overall market will decline, bringing down the value of an individual investment in a particular company, regardless of that company's growth, revenues, earnings, management, or capital structure.

What Are Common Market Risks?

Depending on the nature of the investment, relevant market risks may involve international as well as domestic factors. Key market risks to be aware of include:

• Interest Rate Risk relates to the risk of reduction in the value of a security due to changes in interest rates. Interest rate changes directly affect bonds - as interest rates rise, the price of a previously issued bond falls; conversely, when interest rates fall, bond prices increase. The rationale is that a bond is a promise of a future stream of payments; and therefore an investor will offer less for a bond that pays-out at a rate lower than the rates offered in the current market. The opposite also is true, as an investor will pay more, (known as a premium), for a bond that pays interest at a rate higher than those offered in the current market."

"As an example, consider a 10-year, $1,000 bond issued last year at a 4% interest rate. Is that bond less valuable today, if interest rates have increased, and bonds issued today are offering a coupon rate (interest rate) of 6%? Yes. Conversely, the bond in question would be more valuable today if interest rates had decreased and gone down to 2%."

• Inflation Risk is the risk that over a span of time, 1 year, 2 years, 5 years, 10 years, general increases in the prices of goods and services will reduce the value of a currency, of your money. When this happens, it will negatively impact the value of your of your savings and investments.

For example, let's say the price of a loaf of bread increases from $1 to $2. In the past, $2 would buy two loaves, but now $2 can buy only one loaf, resulting in a decline in purchasing power of money. It’s a simple, but very real example of inflation.

• Inflation reduces the purchasing power of our currency, of our money, and therefore has a negative impact on investments by reducing their value. Inflation risk is often referred to as Purchasing Power Risk. Inflation and Interest Rate risks are closely related as interest rates generally go up as inflation begins to occur, and rates may continue to rise further, right along with inflation. In order that your savings and investments maintain their value, keep pace with inflation, and compensate you for a loss of purchasing power, lenders will demand increased interest rates, and borrowers may have to pay it.
  
  Keep in mind that inflation can be cyclical. During periods of low inflation, new bonds will likely offer lower interest rates, even though existing bonds continue paying higher coupon (interest) rates to their investors. During times of low inflation, investors looking only at coupon rates (again, interest rates), may consider investing in low-grade, or junk bonds that carry coupon rates similar to the ones that were offered previously by higher quality bonds during an inflationary period. Investors need to be aware that such lower graded bonds, even though they may appear to offer higher compensation in the form of higher coupon rates (interest rates), may come with much higher risks of default.


• Currency Risk comes into play if money of one particular country, or today a continent, needs to be converted to a different currency, in order to purchase or sell an investment. In such instances, any change in the exchange rate between one currency and the other, (i.e. Between one currency and the U.S. dollar), can increase or decrease your investment return. This risk will impact you if you invest in stocks or bonds issued by companies based outside the United States or mutual funds that invest in international securities.

"For example, assume the current exchange rate of the US dollar to the British pound is $1=£0.53. Let's say we invest $1,000 in a UK stock. This will be converted to the local currency equal to £530 ($1,000 x £0.53 = £530). Six months later, the dollar strengthens and the exchange rate changes to $1=£0.65. Assuming that the value of the investment does not change, converting the original investment of £530 into dollars will fetch us only $815 (£530/£0.65 = $815). Consequently, while the value of the stock remains unchanged, a change in the exchange rate has devalued the original investment of $1,000 to $815. On the other hand, if the dollar were to weaken, the value of the investment would go up. So if the exchange rate changes to $1 = £0.43, the original investment of $1,000 would increase to $1,233 (£530/£0.43 = $1,233)."

• Liquidity Risk relates to the inability to buy or sell investments quickly for a price that represents the true underlying value of a particular asset. Sometimes you may not be able to sell an investment in a timely manner, or perhaps, not at all. The problem lies in the possibility that there may be no buyers for that particular security, resulting in your investment being worth little or nothing until there is a willing buyer for it in the market. The risk is usually higher in over-the-counter markets and small-capitalization stocks. Foreign investments pose varying liquidity risks as well. The size of foreign markets, the number of companies listed and the hours of trading may be much different from those in the U.S. In addition, certain countries may have restrictions on investments purchased by foreign nationals or repatriating them. Thus, you may: (1) have to purchase securities at a premium; (2) have difficulty selling your securities; (3) have to sell them at a discount; or (4) not be able to bring your money back home."


• Sociopolitical Risk involves the impact on the marketability of a particular investment, as related to political and social events, such as a terrorist attack, war, natural disaster, pandemic, or elections. Such events, whether actual or anticipated, affect investor attitudes toward the market in general, could result in a wide fluctuation in stock prices. Furthermore, some events can lead to wide-scale disruptions of the financial markets, affecting the ability of actual trading of securities, exposing investments to even greater risks.


• Country Risk is similar to the Sociopolitical Risk described above, but tied to the particular foreign country in which an investment is made. It could involve, for example, an overhaul of the country's government, a change in its policies (e.g., economic, health, retirement), social unrest, or war. Any of these factors can strongly affect investments made in that country. For example, a country may nationalize an industry or a company may find itself in the middle of a nationwide labor strike, hence affecting the securities related to that country.


• Legal Remedies Risk is the risk that if you have a problem with your investment, you may not have adequate legal means to resolve it. When investing in an international market, you often have to rely on the legal measures available in that country to resolve problems. These measures may be different from the ones you may be used to in the US. Further, seeking redress can prove to be expensive and time-consuming if you are required to hire counsel in another country and travel internationally."

In regard to securities, legal remedies, and legal risks, consider that a client’s only means of satisfaction when they become disgruntled with the actions, or inactions, of a registered representative who is their financial advisor, is arbitration.
Of course, if fraud or negligence is involved, arbitration is not the only means of restitution, as investors would then be within their freedoms to hire an attorney and bring suit against an individual and/or their broker dealer.
The following story was taken from an investment newsletter, and serves as a valuable example of the individual investors responsibility. Please read on.

"Arbitration Won't Fix It"
"Some of my best article ideas come from my readers, and this week is no exception. This is a story of misplaced trust, dishonesty, inaction and great financial loss. The lessons learned through their experience will hopefully save you from a similar fate.

Bill and his wife, Jane, (not their real names), were a well-educated couple looking to boost their returns. After attending one broker's seminar, Bill was impressed by, his expertise in company analysis and stop-loss protection.

They decided to put Jane's retirement money into this broker's hands. But after signing the paperwork to open the account, the broker never contacted Jane to find out how she wanted her money managed. Both sides made assumptions about what the other wanted and/or would do.

Jane and Bill were busy, and so was Jane's IRA. We don't know how long it took or how the account did early on, but eventually, over 90% of Jane's retirement money went down the tubes.

The broker promised stop-loss protection but never actually put that strategy in place. The broker determined Jane's risk tolerance without any input from her. When that section of the application was left blank, the broker filled it in it himself so that it, according to Bill, would justify his stock picking and mutual fund selection.

Bill and Jane had to go through arbitration in an attempt to recover their losses, as are almost all brokerage firm clients. After a process that typically takes several years, the panel agreed that the broker had violated 26 NASD regulations. These included lying, the use of erroneous information, total mismanagement of the client's accounts and the use of unsuitable investments.

When it was all over, guess who the panel found at fault for Jane's losses?

Jane, of course! They reasoned that since she was a well-educated woman, with a Master's degree no less, that she should have known better than to let it happen. Her husband Bill was even chastised for finding the broker in the first place, and for putting her in a position to lose her money. "We were supposed to know better, not the broker, or his broker-dealer. I am not making this up. My wife got a check for less than 1% of the account value before the losses occurred.

Bill's experience with arbitration is fairly typical. Roughly 50% of arbitration cases are won by the investor, but the award is often a fraction of the damages. Moreover, many times the complaint doesn't even show on the broker's record.

This story has many lessons. Perhaps the most important one is that you bear the primary responsibility for managing your investments. The financial system isn't out to protect the individual investor. Even if you suffer great financial loss, don't expect the system to bail you out."

How Can I Manage Risk?
While you cannot completely avoid market risks, you can take a number of steps to manage and minimize them.

• Diversify: As in the case of business risks, market risks can be mitigated to a certain extent by diversification, not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holdings (short and long-term). You can spread your international risk by diversifying your investment over several different countries or regions.
• Do your homework: learn about the forces that can impact your investment. Stay abreast of global economic trends and developments. If you are considering investing in a particular sector, for example, aerospace, read about the future of the aerospace industry. If you are thinking about investing in foreign securities, learn as much as you can about the market history and volatility, socio-political stability, trading practices, market and regulatory structure, arbitration and mediation forums, restrictions on international investing and repatriation of investment.
• While you cannot completely avoid market risks, you do have other savings options, as you can avoid market risk by placing your money in financial products that guarantee your principal and interest. These products include CDs and annuities. If a bank becomes insolvent, FDIC insurance comes into pay, and if the insurance company becomes insolvent, the "state guarantee fund" comes into play.

Learn more about the various types of savings and investments options available to you and their respective risk levels. Inflation risk can be managed by holding products that provide purchasing power protection. You could consider annuities and/or inflation-linked bonds.

Interest rate risk can be managed by holding the instrument to maturity. Alternatively, holding shorter term bonds, annuities and/or CDs may provide the flexibility to take advantage of higher paying instruments if interest rates go up.

Some investments are more volatile and vulnerable to market risks than others. Selecting investments that are less likely to fluctuate with changes in the market can help minimize risks to a certain extent. Of course any security will have the risk associated the stock market.

Longevity Risk

There will be a time when the distribution or the "decumulation" of your assets will become a priority. Someday, the paychecks will stop, or they may not be what they once were, while you were in your higher earning years. We all need a plan to take income from our savings and/or investments, so we may live comfortably in retirement.
We are all facing longevity risk, caused by living too long, to the point where we may outlive our savings.

The American people have seen a change in the retirement picture, as we are now responsible for funding close to 100% of our retirement. Defined benefit plans; the safety net Americans from past generations had come to count on, have all but disappeared. In the old days, defined benefit plans promised employees a steady monthly income, an obligation of your employer, where you may have worked for 20, 30, or 40 years. These plans are just about extinct.

Today, the emergence of 401-k plans has shifted the responsibility of a steady monthly income in retirement to the average American employee. It is our personal obligation to fund our own retirement. Consider that Social Security Benefits, too, are really a return of your own money. We pay as we go, contributing to the Social Security Trust Fund with deposits from our own paychecks, though American business, along with federal, state, and local governments, still contribute a significant portion, often providing a significant match to our own contributions.

We are all faced with the individual challenge of maintaining the continuous funding of our golden years. We must save for our future income in retirement, to insure we do not outlive our savings. So, when the time comes to turn those savings into a stream of monthly income you can count on, it must be understood that a "retirement spending plan is just as important as a retirement saving plan".

We all know that life insurance protects against dying too soon. Annuities are what protect us against living too long. Therefore, consider allocating a portion of your portfolio towards an annuity.

Annuities can essentially provide "income insurance" in retirement, to make sure your money lasts as long as you do. The fact is, only annuities afford you the opportunity to never outlive your income. In regard to retirement income, the financial services industry is turning to the insurance industry to provide guaranteed monthly income their clients cannot outlive. If you cannot protect your income in retirement, all of the other planning you have done may not matter.

We purchase insurance to protect against uncertainties. We insure our homes, we insure our cars. Retirees may be forgetting about what it is that provides the very things we live on; food, shelter, clothing, the ability to visit friends and family. What about vacations? A very real danger would be to run out of money in retirement, to face retirement without the adequate income we need to live comfortably. Can we really insure our income to last a lifetime? Yes we can, with "income annuities".

We all have a greater chance of living longer, due to healthier lifestyles and advances in healthcare. The following slide illustrates the likelihood of 65 year old couples, one of whom will live to various ages.

Annuities will help ensure that you will not outlive your money.
According to the chart above, if you take a typical 65 year old couple, there is an 84% likelihood that either the man or the woman will live to age 85. According to a survey conducted in 2001, the American Council of Life Insurers found that 88% of Americans agree that, for their retirement, receiving at least some of their savings as regular income payments that they cannot outlive is important.

Annuities enable consumers to turn their savings into a monthly check!
Your deferred annuity is converted into what is called an immediate annuity, often called an income annuity. This immediate annuity will provide an income stream to you, a portion of which may be tax free, if working with non-qualified funds. You could target certain monthly expenses: mortgage, auto-lease etc. You could choose to insure your lifestyle: the ability to take vacations, the ability to visit family and friends, to play golf, to do what you want in retirement! Figure out the amount of monthly income you will need to do all of these things, and a calculation can be made to determine the amount of present dollars you will be required to place into an immediate annuity or a deferred annuity if you will not be needing the income for a few years. Annuities can provide the monthly income you need to live a more joyous retirement!

Conclusion

Investments involve varying levels and types of risks. These risks can be associated with the specific investment, or with the marketplace as a whole. As you build and maintain your portfolio, remember that global events and other factors you cannot control can and will impact the value of your investments. Understand, inherent in investing in the stock market is the risk of loss, and involves both business risk and market risk. If you are averse to market risk, if you cannot accept the risk of loss to your principal in your account value, stocks, bonds, mutual funds, and variable annuities may not be right for you.

If you are conservative, or moderate, and/or do not wish to participate in the ups and downs of the stock market, consider savings products such as CDs or tax-deferred fixed and fixed-indexed annuities.
Furthermore, longevity risk may lead you to consider the use of income annuities.

What you just read was based on the NASD/FINRA Alert IM-2310-2", along with other information relative to banking and insurance products, inserted when appropriate.

Note* The NASD/FINRA offered Alert IM-2310-2, in an attempt to relay what would be considered "Fair Dealing with Customers with Regard to Derivative Products or New Financial Products".

The NASD/ FINRA is attempting to address registered representatives, informing them "it is important that members make every effort to familiarize themselves with each customer's financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products. Registered representatives with a securities license are instructed to follow the specific guidelines, as spelled by Alert IM-2310-2.