Risky Business

Many investors think that they are taking most of the risks when giving control of their assets to be managed professionally, but what they don’t realize is that the firms they are giving that control to are taking risks every day. This sentiment is fairly common, and most investors that employ the services of these firms expect to receive higher returns on their investments because of the professional and expert management they are paying for. This excess return that was dubbed “advisor alpha” was found to be roughly 3%, which varies from client to client based on goals and risk tolerance.

Even though the professionals working for these firms have access to a large supply of data and information for them to make the best possible decisions for their clients, they still face a large amount of risk, primarily through market risk. Market risk, which is also known as systematic risk, is the possibility of negative or positive returns for an investment that is not tied to the firm but rather the financial markets as a whole. This risk is not tied to any specific company or industry but is the risk that the movements of financial markets as a result of macroeconomic trends and consists of three types: interest rate risk, exchange rate risk, and equity price risk.

All of these risks have effects on portfolios for clients that have their assets professionally or personally managed around the world. The importance of this is risk is to acknowledge how much of the future regarding the market is unknown and difficult to determine. Especially in the two years, equity price risk has become very relevant throughout the covid-19 pandemic shutdown and recovery. The impact of the pandemic not only caused a massive drop in the stock market but has also led to an extremely fast rebound that has been met with numerous questions. Inflation, interest rate speculations, as well as current financial events such as the Evergrande story that was released recently, can all have effects on the market.

Currently, one of the developments in financial markets that many investors and firms are carefully tracking is regarding the Federal Reserve and what changes they will make as the world continues to emerge from the COVID-19 pandemic. The Fed’s stimulus programs have been one of the main reasons the stock market has been able to recover so quickly. However, as the economy and society have continued to recover, investors have begun to worry about when the Fed’s generous programs will end, and interest rates will be raised. The Fed chairman, Jerome Powell, recently spoke to this point to address the nervousness of investors and prepare them for the policies of the Fed moving forward. The chairman said that a gradual process of limiting the government’s buyback of assets as well interest rate manipulation that would conclude by the middle of the year in 2022. Addressing this topic is important for the Fed because a sudden or unexpected hike in interest rates would expose many investors to a large amount of market risk. The sudden rise could lead to a rapid pullback by investors and a correlated movement in the market. This is why market risk is so important. It is this risk that is not tied or related to the firm or industry of the investment, but rather the risk that something happens that affects the entire market and leads to potential losses for investors.

The reason that market risk is so important for asset managers, investment firms, and financial advisors is that this is one of the risks that many investors wish to ignore or not consider when investing. People often don’t want to believe that bad things can happen, and it would be a mistake to generalize market risk as just that, but when it comes to investing, potential outcomes and scenarios need to be considered. For any professional that is managing the investment decisions for a firm or people, market risk should be something that is considered. While there is no one perfect way to account for market risk completely, an investor’s or client’s risk tolerance should be taken into account as many types of investments are affected by market risk. There are many options for investors to help hedge against market risk, such as positions in certain derivatives, negatively levered ETFs, or holding more cash. Market risk is important for all types of investors to know about and consider when making investment decisions.

Works cited

McCabe, Caitlin, and Caitlin Ostroff. “U.S. Stocks Finish Higher as Fed Signals Timing for Taper and Interest Rate Hikes.” The Wall Street Journal, The Wall Street Journal, 22 Sept. 2021, https://www.wsj.com/articles/global-stock-markets-dow-update-09-22-2021-11632296835.

Nickolas, Steven. “What Are the Primary Sources of Market Risk?” Investopedia, Investopedia, 13 Sept. 2021, https://www.investopedia.com/ask/answers/042415/what-are-primary-sources-market-risk.asp.