Understanding Investment Risk

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1 Understanding Investment Risk Investments and services offered through Morgan Stanley Smith Barney LLC, and accounts carried by Morgan Stanley & Co. Incorporated; members SIPC Morgan Stanley Smith Barney [CODE] [Expiration Date]

2 Why Are We Here Today? Define investment risk. Identify the various types of risk, including unsystematic and systematic risks. Examine the relationship of risk and return. Discuss techniques for managing investment risk and balancing risk and return. 2

3 What Is Investment Risk? In the simplest of terms, investment risk can be described as uncertainty. The uncertainty that the return on an investment may vary from its expected return. The uncertainty that an investment may result in the potential loss of income or principal. 3

4 Types of Investment Risk Unsystematic Risk Systematic Risk 4

5 Unsystematic Risk Refers to risk factors that are usually unique to a particular investment, company, industry, or market sector. Also known as diversifiable risk. Business Risk Unsystematic Risks Business Cycle Risk Credit Risk 5

6 Business Risk The risk of a decrease in a security s market value as a result of the challenges of doing business in a particular industry or environment. Competitive Environment Market or Technological Changes Poor Management Stock Market S&P 500* ABC Company** *Source: Yahoo Finance. 10/23/08. **Hypothetical Company 6

7 Business Cycle Risk The risk that a company s business and, therefore, its revenue and earnings are tied to economic activity or market trends. 7

8 Credit Risk The risk that a company may default on its promise to pay creditors and to make interest and principal payments to bondholders. 8

9 Minimizing Unsystematic Risk Diversification Issuers/Companies Industries Market Sectors 9

10 Systematic Risks The risk that a security s price will decrease based on the overall performance of the market or the economy. Also known as non-diversifiable risk. Results from overall market volatility and changing economic conditions affecting all securities with a particular asset class. Systematic Risks Market Risk Purchasing Power Risk Interest Rate Risk Currency Risk Political and Legislative Risk 10

11 Market Risk The risk of a decrease in a security s market value due to an overall decline in the market. DOW Jones Industrial Average From Oct 24, 2007 To Oct 23, Dec 2008 Feb Mar Apr May Jun Jul Aug Sep Oct 13K 12K 11K 10K 9K 8K Source: Yahoo Finance. 10/23/08. 11

12 Purchasing Power Risk The risk that an investment s return will not keep pace with inflation. Also known as inflation risk. Impact of Inflation $8 $7 $6.84 $7.39 $6 $5.82 $5 $4 $4.42 $3 $2.78 $2 $1.31 $ Source: Bureau of Labor Statistics Inflation Calculator 10/23/08. 12

13 Interest Rate Risk The risk is that the value of a security will change due to fluctuating interest rates in the market. Interest Rates Bond Prices 13

14 Currency Risk The risk that a fluctuation in exchange rates between currencies will negatively affect the return on foreign securities. USD to EUR Oct 08 Source: Yahoo Finance. 10/23/08. 14

15 Political and Legislative Risk The risk that a security s value may be affected by political and legislative changes that affect ownership rights or the business environment. 15

16 Liquidity Risk The risk that a regular market for a security will not continue to exist resulting in the inability to sell and/or the loss of market value. 16

17 Minimizing Systematic Risk Asset Allocation 17

18 Risk and Return The amount of risk associated with a particular investment is closely related to its expected return. The greater the risk, the greater the potential return. The less risk, the lower the potential return. Risk and Return Comparison Return Small Company Stocks Large Company Stocks Fixed Income Securities Cash/Cash Equivalents Risk 18

19 Risk and Return The amount of risk associated with an investment is usually evaluated by comparing it to the risk-free rate of return. Wealth Indices of Investments in the U.S. Capital Markets From 1925 to 2007 $20,000 $15, $10,000 Small Company Stocks $3, $1,000 Index $100 $10 Long-Term Government Bonds Large Company Stocks $78.78 $20.19 $11.72 Inflation $1 $ Year - end Source: 2008 Ibbotson SBBI Classic Yearbook Risk-free Rate of Return (Treasury Bills)

20 Balancing Risk and Return Diversification Asset Allocation Managing Risk 20

21 Selecting the Right Investments Risk Tolerance Investment Objective Time Horizon 21

22 Selecting the Right Investments Risk Tolerance Investment Objective Time Horizon Diversification Asset Allocation 22

23 Your Financial Advisor Team at Morgan Stanley Smith Barney Y:\Other\Get the Most Out of Your IRA ( ) 8/26/2010 Our Financial Advisors can provide: Access to intellectual strength and global resources of Morgan Stanley Smith Barney Financial solutions that address your specific needs and goals Name [First Name] [Last Name] Title Phone: Fax: Morgan Stanley Smith Barney, Morgan Stanley & Co. Incorporated and Morgan Stanley Smith Barney s Financial Advisors do not provide tax or legal advice, are not fiduciaries (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein, and this material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their tax or legal advisor before establishing a retirement plan or to understand the tax, ERISA and related consequences of any investments made under such plan. 23