Chapter 20

Which investment is most subject to inflation risk? A. Treasury bonds B. Treasury bills C. Utility stocks D. Blue chip industrial stocks

*Treasury bonds* Inflationary risk is associated with prices rising and investors not being able to buy as many goods and services as expected (i.e., loss of purchasing power). Fixed income investments (i.e., bonds) and fixed annuities typically have the most inflation risk. When choosing between two bonds with different maturities, long-term bonds (e.g., T-bonds) have more inflation risk than short-term bonds (e.g., T-bills).

event risk (systematic risk)

Event risk is the risk that a significant event will cause a substantial decline in the market value of all securities (e.g., the 9/11 terrorist attack).

following are exam Qs

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An investor has a portfolio in which 25% is invested in an oil company, 35% is invested in a pharmaceutical stock, 30% is invested in an exchange-traded fund that tracks the S&P 500 Index, and the final 10% is invested in money-market funds. Which of the following risks is inherent in the portfolio? A. Non-systematic B. Political C. Credit D. Liquidity

*A. Non-systematic* Non-systematic risk is specific to one company and can be diversified away by diversifying a portfolio. Since the investor has put 60% of her portfolio into only two stocks, she's not diversified and is exposed to a large amount of non-systematic risk. Credit risk is typically associated with bonds and is the risk that an issuer cannot repay its interest and/or principal. Liquidity risk is the inability to sell an asset easily, which is not a concern in this portfolio since exchange-traded stocks are typically liquid. Political risk is associated with politicians making decisions that will impact an investment.

Which of the following investments has the MOST capital risk? A. Technology stock B. T-notes C. TIPS D. REITs

*A. Technology stock* capital risk is highest for common stock. get capital risk and credit risk straight bitch!

An investor is speculating on the decline in the value of a security and purchases put options on the stock. The news ends up being positive and it results in a rise in the value of the security and the subsequent loss of the entire investment in the put options. This loss is an example of: A. Currency risk B. Capital risk C. Opportunity risk D. Reinvestment risk

*B. Capital risk* This loss is an example of capital risk. Capital risk is the risk of losing all or part of an investment. Opportunity risk is the risk that the investment that's chosen will *yield less* than the yield of another investment that's not chosen.

How can a client minimize principal risk in bonds due to fluctuating interest rates? A. Buy long-term maturities B. Buy short-term maturities C. Buy discount bonds D. Do periodic trading to lock in maturities

*Buy short-term maturities* If an investor buys bonds that have short-term maturities, this will minimize loss in principal due to fluctuating interest rates. The prices of short-term bonds will fluctuate in response to interest rate swings less than the prices of long-term bonds. In addition, premium bonds (those priced above par) are less volatile than discount bonds (those priced below par).

Risks

*Credit risk, also referred to as default risk*, is the risk that a bond issuer will not make interest and/or principal payments on its bonds. *Capital risk* is the risk of losing all or a part of your investment. *Reinvestment risk* is the result of not being able to reinvest at the same rate after a bond matures or is called. *Liquidity risk* is realized when an investment cannot be disposed of quickly and at a price that's related to recent transactions. *Exchange (rate) risk* could result in investors suffering losses due to a foreign currency losing value against the U.S. dollar. However, an investor who buys U.S. dollar denominated (domestic) debt is not subject to exchange risk. *Interest rate risk* is experienced when interest rates rise and prices of bonds fall, which impacts both foreign and domestic bonds. *Repayment risk* is an issue that impacts both foreign and domestic debt, since both foreign and U.S.-based issuers could default. *Political risk* could also impact both foreign and U.S. investments.

A security with a low beta: A. Outperforms the market when it is gaining and losing B. Underperforms the market when it is gaining and losing C. Outperforms the market when its gaining and underperforms the market when its losing D. Underperforms the market when its gaining and outperforms the market when its losing

*D. Underperforms the market when its gaining and outperforms the market when its losing* Beta measures a security's volatility in relation to the market. A security's beta is compared to the beta of the market (i.e., the S&P 500), which has a beta of 1. A stock with a low beta (less than 1) is less sensitive to market movements. In a rising market, a low-beta security will lag in performance. However, when prices are declining, this security will do better since it will generally fall less than the market. On the other hand, a stock with a high beta (greater than 1) will be more sensitive to market movements. A high-beta stock will rise and fall faster than the overall market.

Interest-rate risk (non-diversifiable/systematic risk)

*Interest-rate risk primarily affects existing bondholders*, since the *market value of their investments will decline if interest rates rise*. If rates do rise, new potential investors will not be interested in purchasing existing bonds at par ($1,000) due to the fact that they can obtain higher yields by purchasing newly issued bonds with higher coupon rates. For that reason, the *prices of existing bonds will need to be lowered to attract purchasers.* *diversification*: Diversification doesn't help with non-diversifiable risk. A diversified portfolio of bonds from different issuers with different coupon rates, maturity dates, and geographic locations will provide protection against some risks, but *NOT* against interest-rate risk. In other words, *since all bonds have some exposure to interest-rate risk, it's considered systematic or non-diversifiable.* *duration*: Bonds with *longer maturities* tend to be *more vulnerable to interest-rate risk* than bonds with shorter maturities. Also, bonds with *lower interest rates* are more sensitive to interest-rate risk than bonds with similar maturities and higher coupon rates. *Duration* measures the *sensitivity* of a bond or portfolio of bonds to a given change in interest rates. Duration is *measured in years*, but for practical purposes, a *bond's change in price is based on its duration*. --For example, if a bond's duration is 10 years, a 1% increase in interest rates will cause a 10% decrease in the bond's price. Some investors will spread out (*ladder*) their bond *maturities* to minimize the impact of interest-rate risk by having a portion of their holdings in shorter term bonds. *Interest rates and equities*: Stock prices may also be influenced by interest rate changes. For example, when interest rates are rising, *utilities stocks* will be *adversely affected* because these companies are heavy *borrowers (leveraged*). However, stocks of cosmetic companies (defensive stocks) are not as affected by rising interest rates, which is due to the nature of their business and the low cost of their products. If interest rates rise, preferred stocks will react in a manner that's similar to debt securities. In other words, *preferred stock prices have an inverse relationship to interest rate changes.*

A individual has a mix of small-cap growth stocks, large-cap stocks from mature industries, investment-grade bonds, speculative bonds, preferred stock, and foreign securities. She is attempting to reduce: A. Liquidity risk B. Credit risk C. Money-rate risk D. Market risk

*Market risk* Market risk is reduced (not eliminated) by investing in different asset classes. The more random the correlation between the different asset classes, the greater the overall reduction in market risk. A high positive correlation between the asset classes equates to high market risk.

Which statement is TRUE when comparing penny stocks and blue chip stocks? A. Blue chip stocks pay lower dividends than penny stocks B. Both penny stocks and blue chip stocks have currency risk C. Blue chip stocks have more business risk than penny stocks D. Penny stocks are less liquid than blue chip stocks.

*Penny stocks are less liquid than blue chip stocks.* Penny stocks are not listed on traditional stock exchanges and are less liquid than blue chip stocks. Blue chip stocks typically pay higher dividends than penny stocks. Currency risk is typically only associated with foreign investments.

Which of the following is exposed to the greatest amount of capital risk? A. Common stocks B. Corporate bonds C. American depository receipts D. Equity options

*equity options* Capital risk is the risk of a person losing all or part of his investment. For options, a relatively small change in the value of the underlying investment can result in the entire loss of an investment in options (i.e., a loss of the option's premium).

Which of the following risks does not apply to both foreign and domestic debt instruments? A. Political B. repayment C. Exchange D. Interest rates

*exchange* Exchange (rate) risk could result in investors suffering losses due to a foreign currency losing value against the U.S. dollar. *However, an investor who buys U.S. dollar denominated (domestic) debt is not subject to exchange risk*. Interest rate risk is experienced when interest rates rise and prices of bonds fall, which impacts both foreign and domestic bonds. Repayment risk is an issue that impacts both foreign and domestic debt, since both foreign and U.S.-based issuers could default. Political risk could also impact both foreign and U.S. investments.

Which of the following types of risk would have the greatest impact on a 20-year corporate bond during the first year of the investment? A. Interest-rate risk B. Liquidity risk C. Market risk D. Inflation risk

*interest rate risk* A change in interest rates would most likely have the greatest impact on the bond in the first year of the investment. If interest rates were to go up or down, that could dramatically change the bond's price. The risk presented by inflation would be significant over a longer term. Liquidity risk is the risk that a security cannot be traded quickly enough in the market to prevent a loss (or make the required profit). Market (systematic) risk is the risk that a security's value may decline over a given period due to economic changes or other events that impact large portions of the market.

Which types of investments have historically shown a great deal of sensitivity to regulatory risk? A. Limited partnerships B. Corporate bonds C. Common stocks D. Variable annuities

*limited partnerships* Regulatory risk is the possibility that changes in regulations can have an adverse impact on the value of investments. This is very similar to legislative risk, which is the risk associated with changes in laws. Although all kinds of investments can be subject to regulatory and legislative risk, limited partnerships have historically been particularly vulnerable. For example, adverse changes in the tax laws can cause the value of many limited partnerships to decline.

During a period of rising interest rates, an individual who invests in mortgage-backed securities is MOST concerned with: A. Credit risk B. Opportunity risk C. Legislative risk D. Prepayment risk

*opportunity risk* Like most debt instruments, mortgage-backed securities (MBSs) are subject to interest-rate risk (i.e., the risk that a debt security's value will fall as interest rates rise). However, during a period of rising interest rates, prepayment risk is less of a factor and opportunity risk becomes more important. Since the existing investments will be earning less than new MBSs, the existing securities could be liquidated at a loss and new MBSs could be purchased to take advantage of their higher return.

(for my own knowledge--not in book) Global Industry Classification Standard also known as GICS is the primary financial industry standard for defining sector classifications.

-Energy -Materials -Industrials -Consumer Discretionary -Consumer Staples -Health Care -Financials -Information -Technology -Telecommunication Services -Utilities -Real Estate

Attempting to control risk through diversification

Allocating assets into an optimal portfolio based on a client's risk tolerance and investment objectives is also referred to as *strategic asset allocation.* In theory, an optimal portfolio is the best mix of assets based on the client's goals and level of risk aversion. However, since various asset classes provide differing rates of return over time, the original asset allocation will eventually *drift* from the initial mix. For purposes of determining what's best for a client, there are numerous thoughts regarding any shift in asset allocation. This next section will examine different approaches for clients who either do or don't choose to make a portfolio correction.

buy-and-hold strategy

Any investor who follows the buy-and-hold approach will *not change her asset allocation.* By not restoring the original strategic asset allocation, *transaction costs and tax consequences are minimized* since there's no selling or purchasing of assets. In addition, the portfolio retains any assets that may be steadily appreciating. However, *one* of the problems with the buy-and-hold approach is that, as the asset mix of the portfolio drifts, its *risk/reward characteristics are altered*. In particular, its *volatility*—as measured by the portfolio's standard *deviation*—may become quite different from the original allocation. In fact, the difference may be so significant that it's no longer compatible with the client's risk tolerance.

alpha

As referenced earlier, beta measures how volatile an investment is relative to the market as a whole. However, *alpha measures the risk that's specific to a particular company*. Using beta, investors can predict a stock's rate of return. Thereafter, *alpha can be calculated by taking what the stock actually earned and subtracting its expected return*. For example, based on its beta, a stock is expected to earn 5%. If the stock actually earned 8%, then alpha was 3% (8% - 5%). On the other hand, if the stock only earned 4%, the alpha is -1% (4% - 5%).

business risk (diversifiable risk)

Business risk is the risk that certain circumstances or factors may have a negative impact on the *operation or profitability* of a specific company. For example, a company's prospects may suffer due to either increased competition or decreased demand for its goods or services.

Call risk (diversifiable risk)

Call risk is the risk that an issuer may decide to *pay back its bondholders prior to maturity*. Bonds are typically called when *interest rates fall*; therefore, bondholders receive their money back early and are unable to earn the same return when searching for a replacement investment.

Capital risk (diversifiable risk)

Capital risk is the risk that an investor could *lose all or a portion of her investment.* Purchasers of *options* are significantly impacted by capital risk because, if the options purchased expire worthless, the investor will lose 100% of his capital. On the other hand, if an investor purchased a stock at $50 and it declined to $40, his loss of capital is 20% (10 point loss ÷ $50 purchase price).

credit risk (diversifiable risk)

Credit risk or *default risk* is the risk that a bond issuer will not make payments as promised. *U.S Treasuries are assumed to have virtually no credit (default) risk*. The ratings companies that were described in Chapter 4 provide information to market participants concerning the credit risk of an issuer's bond offering.

currency options

Currency options allow investors to *take a position based on the value of a foreign currency as it compares to the U.S. dollar.* These contracts are *U.S. dollar-settled*, which means that there's no delivery or receipt of a foreign currency if the option is exercised. In the U.S., there are *no calls or puts available on the U.S. dollar*; instead, investors take *option positions on a foreign currency* with the U.S. dollar on the other side of the contract. An *investor's gain or loss is based on the inverse relationship between the value of the foreign currency and the value of the U.S. dollar.* Let's consider how a U.S. importer may use currency options for hedging purposes. For example, ABC Importers is based in the U.S. and is buying goods from a company in France. ABC enters into a contract in which it will acquire goods from the French company and must pay for the goods in euros. ABC's *costs will rise* if the value of the *euros rise and the value of the U.S. dollar falls*. As a hedge, ABC Importers may *buy euro calls* since the options will become more valuable if the *euro does rise in value*, which will *offset the higher costs for the French goods.*

Currency (exchange-rate) risk (diversifiable risk)

Currency or exchange-rate risk is the possibility that *foreign investments will be worth less in the future* due to changes in exchange rates. For example, an American investor owns a British stock that pays a quarterly dividend. The real value of the dividend to the investor will decline if the British pound *weakens against the U.S. dollar*. This is because the British pounds received will buy fewer American dollars when converted. *Foreign securities, global funds, international funds, and ADRs all have a high degree of exchange-rate risk.* Currency risk may also impact the *price* of a company that's based in the U.S. if it *earns revenue in a foreign country*. For example, a U.S. company sells its products and services in Europe and earns revenue in euros. *If the U.S. dollar increases or strengthens in value, the euro will decline* and cause the dollar value of this revenue to fall. In addition, if the dollar strengthens, this company's products will be *less competitive* in Europe and result in the company exporting less

index options

Equity options are effective tools for protecting single stock positions; however, there's an easier way to hedge a portfolio against risk. Let's assume that an investor is worried about a market *crash*. She could *buy put options on a broad-based index*, such as the S&P 500. If the value of the underlying index decreases below the strike price, the intrinsic value of the options increases. In this case, the investor has essentially purchased a blanket policy that *covers her entire stock portfolio*. What if the investor has a more concentrated position? In this case, she could *buy put options on a narrow-based (specialized) index* to adequately protect her position.

equity options

If an investor has an existing stock position, an equity *option* can be purchased as an effective hedge. If an investor has a *long position in a stock*, she could *purchase a put option* which provides protection against a possible *decline* in the value of the stock. The reason that a put purchase is a hedge is that it gives the investor the *right to sell* the stock at the option's strike price if the stock declines in value. On the other hand, if an investor has an existing *short stock* position, he may choose to purchase a *call option* to protect against a potential increase in the value of the stock that was sold short. The reason that a call purchase is a hedge is that it gives the investor the *right to buy* the stock at the option's strike price and to use the acquired stock to *cover the short position.*

prepayment risk (diversifiable risk)

In addition to the risks inherent in all fixed-income investments (e.g., interest-rate, credit, and liquidity risk), *mortgage-backed securities are subject to a special type of risk that's referred to as prepayment risk*. This risk is tied to homeowners *paying off their mortgages early*. When *interest rates fall,* homeowners have an incentive to refinance and pay off their existing mortgages. These prepayments are passed through to the pools that hold the old mortgages. At this point, the *pass- through investors will need to reinvest this large amount of principal at a time when interest rates have declined and will likely have difficulty matching their existing coupon rates* and returns when seeking new investments.

Unsystematic (diversifiable) risk

In contrast to systematic risk, unsystematic risk is based on circumstances that are *unique* to a *specific* security and may be managed by *diversifying* the assets in a portfolio (i.e., by selecting stocks possessing *different risk-return characteristics*). The following are different types of unsystematic risk: *business risk, regulatory risk, legislative risk, political risk, liquidity risk, opportunity (cost) risk, reinvestment risk, currency (exchange-rate) risk, capital risk, credit risk, call risk, prepayment risk*

Inflation (purchasing-power) risk (systematic risk)

Inflation (purchasing-power) risk is experienced by investments that provide *fixed payments* (e.g., *bonds and fixed annuities*). Inflation is the rising price levels of goods and services as measured by the Consumer Price Index (CPI). Ultimately, inflation diminishes the real value of a dollar by decreasing its purchasing power. Historically, *equity securities, variable annuities, investments in real estate, or precious metals (e.g., gold and silver) have provided the best protection against inflation.* Inflation hurts bondholders in two ways, 1) inflation leads to *rising interest rates* which causes the *market prices* of their *existing bonds to fall*, and 2) the *purchasing power of their interest payments decreases.* As stated previously, many market professionals measure an investment's *real rate of return* (for *bonds*, it's also referred to as the *real interest rate*). The formula for calculating real rate or return is an investment's return minus the rate of inflation (as measured by the Consumer Price Index, or CPI). For example, if an investment has an 8% return and CPI is 3%, the real rate of return is 5%.

indexing

Investors who *subscribe to the efficient market hypothesis and believe that market timing is ineffective* usually *favor buy-and-hold strategies and engage in market indexing*. *Indexing* involves either maintaining investments in companies that are part of *major stock (or bond) indexes* or investing in *index funds directly*. Some of the indexes on which funds may be based include the DJIA, the S&P 500, the S&P 400, or the Russell 2000. An *actively managed* fund attempts to *outperform* a relevant index through superior stock- picking techniques; however, the composition of an index changes infrequently. On average, an index fund manager makes *fewer trades than an active fund manager.* The result of indexing is that there are lower trading expenses than actively managed investments and *fewer tax liabilities* to be passed on to shareholders.

Active strategies

Investors who believe *securities markets are not perfectly efficient* may utilize an *active strategy* (e.g., *market timing*) to alter their portfolio's asset mix in order to take *advantage of anticipated economic events*. This market timing approach is often referred to as *tactical asset allocation.* (An investor's portfolio currently has an asset mix of 35% large-cap, 15% mid-cap and 10% small-cap equity index funds, 30% bonds, and 10% money-markets. If the investor is employing an active asset allocation approach and believes that small-cap stocks will outperform the market as a whole, what action could he take? The investor could increase the small-cap stock allocation from 10% to 15% and reduce the mid- cap stock allocation. If the small-cap sector appreciates as predicted, the investor could then sell out of the small-cap asset class and reallocate into a different asset class. Essentially, the investor is trying to identify and buy into sectors that will outperform the market.) This approach is not what dad likes-- you can't outperform the market!! Market really is unpredictable you can't try to predict it

Legislative risk (diversifiable risk)

Legislative risk is the risk that *new laws* may have a negative impact on an investment's value. Changes in the law can occur at any level of government and can potentially affect all sorts of investments. For example, an increase in the legal drinking age could hurt the sales of a beer producer.

liquidity risk (diversifiable risk)

Liquidity risk is the risk that investors may be *unable to dispose of a securities position quickly and at a price that's reasonably related to recent transactions*. This type of risk tends to *increase* as the *amount of trading* in a particular security *decreases*. For instance, the shares of large blue-chip companies are highly liquid, while the stocks of small companies are typically less liquid. *Investments which are not traded in the market, such as hedge funds, private placements, direct participation programs (limited partnerships), and real estate have a significant lack of liquidity.*

Market risk (a Non-diversifiable risk)

Market risk represents the day-to-day potential for an investor to experience losses due to market fluctuations in securities' prices. Any security being bought and sold can decline as it's traded in the market. In a prolonged bear market, *most stocks will trade down* regardless of the company's individual prospects. *Beta - Measuring Non-Diversifiable Risk*: Avoiding *diversifiable risk* is as simple as constructing a portfolio of *relatively uncorrelated assets* (those with movements that are unrelated); however, non- diversifiable risk must be approached differently. The reason for this is that the amount of risk being assumed by a portfolio is directly related to its expected return. *The amount of non-diversifiable risk associated with a particular portfolio or asset is measured as beta.* The value of beta describes the *risk of a portfolio or asset as compared to the total market*, which is measured as volatility. The total market (typically considered the S&P 500 Index) is assigned a *beta value of 1.0.* Stocks or portfolios with betas *above 1.0 will have greater volatility than the market* and those with betas *below 1.0 will have lower volatility* than the market. Most market professionals use the term beta when referring to the volatility of equity securities.

hedging

Once assets are allocated into a client's optimal portfolio, the client may ask, "Are there ways for me to reduce risk?" For many, the answer is *yes* and it's referred to as hedging. Hedging (protection) essentially involves the client *buying insurance* to *guard against the market moving against her.*

Dollar Cost Averaging (DCA)

Once the selection has been made regarding the best assets to purchase, investors may choose to use a systematic approach to investing. With *dollar cost averaging*, a person invests a *fixed-dollar amount* at *regular intervals*, *regardless* of the *market price* of the security. This fixed-dollar approach may be used rather than trying to *predict the best time* to invest. An investor using dollar cost averaging will be able to buy *more shares when the price is low, but fewer shares when the price is high*. As a result, the *investor's average cost per share is lower than the average of the prices at which the investor purchased the shares.* This method of investing makes *no attempt to time the market*; instead, investors buy regardless of whether the market is high, low, or somewhere in the middle. This technique is designed to take the emotion out of the investment process and accepts that markets are subject to erratic swings.

Opportunity (cost) risk (diversifiable risk)

Opportunity cost or opportunity risk represents the possibility that the *return* of a selected investment is *lower* than another investment that was not chosen. For example, an investor may be planning to hold a bond until maturity and is therefore unconcerned with the potential decline in its price if interest rates rise. After all, as long as there's no issuer default, he will receive the bond's par value at maturity. Of course the problem with this approach is that it fails to take into account the *higher return* that the investor *could have possibly earned* from an alternative investment.

Political risk (diversifiable risk)

Political risk is simply defined as the risk that *foreign investors will lose money* due to changes that occur in a country's government or regulatory environment. This risk is typically associated with emerging markets countries and may include acts of war, terrorism, and military coups.

portfolio rebalancing

Portfolio rebalancing involves a process of *buying and selling assets on a periodic basis.* Through rebalancing, the original strategic asset allocation—and its risk/reward characteristics—may be *restored.* With this approach, adjustments may be based on either *time or value*. If *time* is used as the focus, portfolio rebalancing may be done based on a *prearranged schedule* (e.g., monthly, quarterly, or annually). On the other hand, if adjustments are triggered by *value change*, the need to rebalance is based on an *asset class growing or shrinking beyond a set tolerance level from the original allocation* (e.g., ±10%). *More frequent rebalancing* will keep a client's portfolio closer to its strategic allocation. However, more frequent rebalancing will result in higher *transaction costs* as some assets are sold and others are purchased. Both the buy-and-hold and systematic rebalancing approaches *assume that markets are efficient.* Or, to put another way, it's impossible to time changes in asset balances to take advantage of market movements. These passive approaches to asset allocation are in agreement with the market theory which is referred to as the *Efficient (Capital) Market Hypothesis.*

Regulatory risk (diversifiable risk)

Regulatory risk is the risk that *regulatory changes may have a negative impact* on an investment's value. For example, an FDA announcement denying approval of a new drug may cause the price of a pharmaceutical company's stock to decline.

reinvestment risk (diversifiable risk)

Reinvestment risk is the risk that an investor will *not be able to reinvest her principal at the same interest rate after a bond matures or is called*. This situation typically occurs when *interest rates have fallen*. At this point, the investor typically has *two* choices, 1) accept a lower rate of return, or 2) assume a higher degree of risk to keep her returns stable. Reinvestment risk is also evident if market interest rates have declined and a bond investor is forced to reinvest her bond's interest payments at a lower rate.

sector rotation

Sector rotation is an investment strategy that involves moving money from one industry or sector to another in an attempt to *beat the market*. Since not all sectors of the economy perform well at the same time, this method of asset allocation may allow investors to profit as the economy moves from *one cycle to another.* The business (economic) cycle follows a certain pattern—*early recession, full recession, early recovery, and full recovery*. Although the length and severity of any of these stages may vary, this is the general pattern. *Certain sectors of the economy tend to do better than others during different stages in the business cycle*. For example, during the *early part of a recession, utilities tend to perform well, while airlines tend to do badly since people have less discretionary income to spend on travel.* A portfolio manager who employs a sector rotation strategy will try to anticipate the next turn in the business cycle and shift assets to the sectors that will derive the most benefit. Therefore, if the manager believes that a recession is near its end and the economy is *entering the recovery period*, she would begin shifting funds to the sectors that would profit the most from the change, such as *companies that make durable consumer goods (e.g., automobiles, appliances, etc.).*

Systematic (Non-diversifiable) Risk

Systematic risk is caused by factors that affect the prices of virtually all securities. *Interest rates, recession, and wars* all represent sources of systematic risk since they affect all securities markets to some degree and *cannot* be avoided through diversification. The following are different types of systematic risk: *market risk, interest-rate risk, inflation (purchasing power) risk, event risk*

Investment risks

When recommending specific securities or financial plans to clients, financial professionals are required to consider various factors. Among these factors are the *client's financial holdings, risk tolerance, investment objectives, and related risk factors*. This first section will outline some of the key risk factors that registered persons should discuss with clients prior to making recommendations. The concept of diversification will also be described, which in simple terms means not putting all of your eggs (investment dollars) in one basket. One example of utilizing diversification is purchasing shares of a mutual fund that owns a large collection of stocks, rather than purchasing the stock of one company. To expand on the concept of diversification, let's begin a deeper discussion of risk. *Investment risk is divided into two major categories—diversifiable and non-diversifiable.*

hedging strategies

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