Understanding Market Risk When You Invest
When you invest your money, you probably know you’re taking on a certain amount of financial risk. Unlike depositing money in a bank, where it is often insured and can earn a steady amount of interest, investing doesn’t offer financial certainties. You could earn a great deal of money on your investments, but you also face the risk of losing money.
In general, the more financial risk you’re willing to take on in an investment, the greater your chance of potentially earning higher returns. Higher financial risk will also increase the losses you might face on your investments. However, investors also face risks they don’t necessarily get to choose when they’re selecting investments. “Market risk” is one of those.
Defining Market Risk
Market risk refers to financial factors that can impact an overall economy. Market risk can affect the economy of just one country—such as the U.S.—or it can affect international economies, too. Whenever a geographic area faces a widespread recession, governmental change, natural disaster or other major factors, that area’s financial markets will usually reflect the impact.
Generally, some amount of market risk is inevitable with every investment. Even the most experienced investors can’t completely eliminate market risk. However, smart investors may be able to soften their potential financial losses during a down market by diversifying their portfolios and using what are called market risk “hedging strategies.”
First, though, it’s important to understand the typical market risks all investors face.
The Four Most Common Market Risks
When it comes to market risk, you’ll likely hear about these primary factors:
• Interest rate risk: When overall interest rates shift, your investments can be affected, too. Fixed-income investments like bonds tend to be most directly impacted by interest rate changes. If interest rates go down, bond prices typically tend to swing upward. And when overall interest rates go up, bond prices tend to fall. Investors who own a lot of bonds or bond funds can face significant market risk whenever interest rates shift.
• Equity price risk: Equities, or stocks, tend to be riskier than many other types of investments. Equity price risk just refers to the chance that a particular stock will decrease in value after an investor buys it.
• Currency risk: Whenever there’s a significant change in the price of different countries’ currencies compared to each other (their exchange rates), currency risk is an issue. For example, your investment in a European stock might face some losses because the euro – U.S. dollar exchange rate changed. Currency risk is always a concern for investors who have international holdings.
• Commodity price risk: Commodities are raw materials, such as corn, crude oil, cotton and steel. These materials are used directly and sold to produce other products. Big price changes in key commodities can affect investors who invest directly in commodities or in companies that rely heavily on these materials. Commodity prices can be affected by a wide range of factors, including severe weather, supply and demand, currency exchange rate and regulatory changes.
Strategies for Reducing Market Risk
There’s no way you as an investor can completely eliminate exposure to overall market risk. However, there are things you can do to help your portfolio weather any big market moves.
One way is to diversify your investments. Consider putting money into different asset classes (such as equities, bonds, commodities and real assets). Within equities, consider different industry sectors (such as technology, health care and energy).
You can also diversify by investing in index mutual funds and exchange-traded funds (ETFs) that invest in thousands of different types of companies.
With so many factors to consider, a Financial Advisor can help you sort through the options to develop a diversified investment strategy that reflects your individual risk tolerance and broader financial goals. The bottom line: The more you understand the basics of market risk, the better you can prepare your investments to face it.
Article by Morgan Stanley and provided courtesy of Morgan Stanley Financial Advisor.
Brian P. Jacobs is a Wealth Advisor in Valencia, CA at Morgan Stanley Smith Barney LLC (“Morgan Stanley”). He can be reached by email at firstname.lastname@example.org or by telephone at 661-290-2022.
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