What Is Market Risk?
Market risk is the possibility that an investor will experience a loss in a financial investment due to various factors that affect the performance of an overall market. Fluctuating interest rates, stock price changes, shifting exchange rates, and the price of commodities are all factors that can impact a market’s performance and contribute to market risk. Market risk is also known as systemic risk or undiversifiable risk.
- The most common market risk types include commodity risk, currency risk, interest rate risk, equity risk, and inflation risk.
- Market risk cannot be eliminated through diversification but can be managed through hedging investments.
- Investors can hedge their investments by buying put options, shares of hedged mutual funds, or inflation-hedging commodities.
- Investors in 2022 have seen market risks become realities through rising inflation and interest rates, commodity shortages, declining stock values, and shifting currency rates.
What Are the Different Types of Market Risk?
Volatility in the price of goods such as oil, food, and building materials impacts the performance of companies in every industry. A change in commodity prices is typically caused by an imbalance in supply and demand. Geopolitical conflicts, natural disasters, weather patterns, and political policies can result in a supply and demand shift, causing prices to rise or fall.
For example, in 2016, the price of steel rose 50%, while rubber’s price increased by a whopping 70%. As a result, the construction, automotive, and manufacturing industries’ profit margins dropped. Businesses across numerous industries saw their operation costs rise as they were forced to pay more for automobiles, manufactured products, and new construction. Investors in nearly every industry experienced losses related to this shift in commodity prices.
Currency risk, or foreign exchange risk, is a market risk that applies to investors doing international business. An investment may decline in value due to the depreciation of a foreign currency.
For example, in September 2022, the value of the British pound fell to a record low against the U.S. dollar. Similarly, the currencies of South Korea, Japan, and the European Union declined against the dollar. U.S. investors doing business in countries with depreciating currencies will experience a decreased profit when converting money into U.S. dollars.
Interest Rate Risk
When the cost of borrowing money rises or falls, investors can experience huge fluctuations in ROI. This is called interest rate risk.
For example, an investor may create a plan to start a company using borrowed money. The plan would likely include the expected cost of operating the business compared to the expected revenue. If interest rates rise, the investor could be stuck with lower-than-expected profits because their business plan failed to account for the higher cost of borrowing money.
Bond investors also lose money when interest rates rise. If an investor purchases a bond with a fixed income return of 5%, but interest rates rise to 7%, the investor will struggle to sell the bond because demand for the lower-rate bond will fall.
Equity risk is the possibility that investors will lose money when the price of a security drops. It can be a type of market risk but is not always. When the price of one particular stock drops, this risk is can be mitigated through diversification, meaning it is not a market risk.
However, in a global economic crisis, like the 2007 stock market crash that triggered a global recession, stocks across industries and asset classes lose value. Between 2007 and 2009, the stock market lost approximately 50% of its value. This was an example of equity risk that applied to the whole market.
Inflation risk is the risk that the depreciating value of money will impact investor returns. In an inflationary environment, purchasing power decreases, increasing expenses and cutting profits. Because moderate inflation is expected, most investors account for a small amount of decreased purchasing power each year. However, when inflation rates are much higher than expected, investors can experience significant losses.
How Market Risk in 2022 Impacted Investors
In 2022, many investors experienced significant losses after numerous market risks became realities. Following a downward trend that began in January, the S&P 500, Dow Jones, and NASDAQ experienced new lows for the year in late September, bringing total declines to over 20%.
The stark drop in stock prices in September is an example of equity risk. The drop came after the U.S. central bank announced the third 75-point interest rate hike of the year and the fifth interest rate hike overall. Raising interest rates is a monetary policy enacted to battle high inflation. This represents how different types of market risk influence each other.
2022 Impacts of Market Risk
- Commodity Risk: Due to the Russia-Ukrainian war, energy prices have skyrocketed in 2022. Labor shortages, natural disasters, and supply chain disruptions leftover from the COVID-19 pandemic have also caused shortages of several grocery staples, lumber, and microchips necessary for modern cars and other high-tech products. These shortages have caused price increases for products in nearly every industry, wreaking havoc on company profits.
- Currency Risk: The U.S. dollar has risen 14% in 2022 compared to a basket of other currencies. U.S. companies that do business in foreign countries may see a dent in profit due to the declining value of many foreign currencies.
- Interest Rate Risk: Interest rates in 2022 have experienced faster increases than the U.S. has seen in decades. The changing interest rate has impacted the real estate market as the number of buyers on the market has quickly dropped. Many companies that benefited from the ability to borrow money cheaply in recent years have had to reevaluate their budgets and cut back expenses, as the cost of borrowing has risen tremendously.
- Inflation Risk: While inflation rates were on the rise in 2021, experts predicted inflation would cool throughout 2022. Unfortunately, rather than slowing down, as of September 2022, the inflation rate sits at 8.2%, the highest inflation rate the U.S. has seen in 40 years. This has resulted in a loss of purchasing power for individuals, businesses, and investment groups.
Understand Your Risk Level
“Knowledge is power. So, you want to make sure you’re researching everything you can.”Ryan Yactman, President and Chief Investment Officer of YCG Investment
While market risk cannot be eliminated, it can be understood and managed. A financial advisor can help you understand your risk levels by calculating your portfolio’s beta.
The beta is a measurement of the volatility of a security compared to the market as a whole. A security with a beta higher than 1.0 is more volatile than the S&P 500. This means when the market is up, your portfolio may earn greater returns than the average portfolio. However, when the market is down, your portfolio will take a larger hit to its profits.
If you have a low-risk tolerance, you’ll want to build a portfolio with a beta close to 1.0. This will keep you from losing large amounts when market risks impact the financial markets.
Managing Market Risk by Hedging Your Investments
Once you understand your risk levels, you can practice risk management through hedging. Hedging acts like an insurance policy, helping investors limit losses when a certain market risk is realized. Listed below are a few common hedging strategies.
A put option is a security that gives you the right to sell a stock at a future date for a predetermined price. This protects investors from equity risk. For example, if you have a share in a stock worth $100, you can purchase a put option with a strike price of $80. This means, no matter how far the stock’s value falls, you have the right to sell it for $80. Investment analyst Richard Coffin says, “When owned alongside the stock itself, this type of option is the closest thing you can get to an actual insurance policy on a stock.”
Hedged Mutual Funds
Hedged mutual funds are pooled investment funds that contain a basket of securities. These funds contain securities that move in contradiction to each other and can be used to protect against most types of market risk.
For example, currency-hedged mutual funds are common in Canada because Canadian investors with U.S. investments see lower returns when the U.S. dollar depreciates.
Coffin explains how currency-hedged funds protect investors when the U.S. dollar is in decline. “The mutual fund may own certain investments that will appreciate when this happens, offsetting the decline and allowing investors to earn a return similar to what they would see if they were investing as Americans,” he explains.
Inflation Hedging Commodities
To hedge against inflation risk, many investors buy commodities that increase in value during inflationary periods. Real estate is a popular inflation-hedging commodity because inflation drives rental income up.
It’s important to remember that there are risks in real estate as an inflation hedging strategy, just as there are with all hedging strategies. Hedging protects you from some risks while exposing you to others. But a well-planned hedging strategy allows these risks to balance each other out.
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