Investments are always connected to risks. As part of our stress test, we inform you in detail about potential and relevant risks. We refer you to the relevant information and documents. But we would like to draw your attention to some essential risks in connection with investments in general as well as with the stress test in particular. We will also explain the risks of the different types of investments that are included in the stress test.
2. General Risks of Financial Investments
2.1 General Market Risk
The investor bears all risks of changes to the market price, for example in the case of stock prices, interest rates or exchange rates. These can lead to strong fluctuations of the assets’ value and lead to losses, including the risk of total loss. They may be based on changes to the economic, cyclical, legal, tax, social, political or other conditions that have an effect on the value of financial instruments.
2.2 Risk of Price Fluctuation
The investor bears the risk of asset prices fluctuating over time. These fluctuations are referred to as the risk of price fluctuation or volatility. They are calculated based on historical data or implicitly from the prices of options. The higher the risk of price fluctuation or the volatility of a financial instrument, the riskier it is.
2.3 Risk of changing Interest Rates
The general interest rate level of a country or a currency area depends, among other factors, on the base rate set by the competent central bank. If a central bank raises the base rate, the general interest rates in its currency area will rise and the prices of bonds will fall. This may lead to financial losses for the investor.
2.4 Bankruptcy Risk
The investor bears the risk that a company cannot meet its payment obligations and becomes bankrupt. In the case of bankruptcy, outside creditors receive preferential treatment over equity providers when the company’s bankruptcy estate is distributed. But both outside creditors and equity providers face the risk of losing their complete investment. Hence, both shares and bonds are subject to bankruptcy risks, possibly resulting in financial losses for investors.
2.5 Solvency Risk
The investor bears the risk that prognoses about a company’s ability to meet its payment obligations may deteriorate. This is referred to as deteriorating solvency of a company. With worsened solvency, companies usually have to pay higher rates of interest. Indications about the solvency of a company are published by ratings agencies, among others. If the solvency of a company deteriorates, the investor may suffer financial losses.
2.6 Dividend Risk
Companies may pay out profits to their shareholders in full or in part. These payments are called dividends. Because future profits and other events that prevent or diminish the dividend are hard to predict, shareholders bear the risk of receiving a smaller dividend or none at all. This may lead to financial losses for the investor.
2.7 Inflation Risk
The investor bears the risk of both the value as well as the returns of the assets being reduced by devaluation or inflation. In the case of an investment, the real return (real interest), meaning the difference between interest, dividends or rising prices and the rate of inflation, has to be kept in mind. This may lead to negative real interest rates if the rate of inflation is higher than the return of the assets.
2.8 Currency Risk
The investor bears the risk of the value of investments in foreign currencies being reduced due to currency risks. If investments are made in a foreign currency, the return on investment not only depends on the nominal return of the investment in the foreign currency, but also on the development of the exchange rate of that foreign currency. Financial losses may occur if the foreign currency in which the investment was made will be devalued against the investor’s national currency. There are currency risks for all investments in foreign currencies, particularly for shares, bonds and other financial instruments denoted in a foreign currency or being paid out in a foreign currency.
2.9 Country-specific Risks
The investor bears the risk that the value of investments in foreign currencies will be reduced by country-specific risks. A foreign country or currency area may influence the capital flows and exchange rates of its currency. This can cause financial losses to an investor, for example when debtors resident in such a country or currency area cannot pay their debts in time despite sufficient liquidity. The reasons for such influence can be manifold, among them a lack of foreign currency reserves, war or social upheaval in the country or in the currency area.
2.10 Risk of Economic Cycles
The investor bears the risk of the value of the assets fluctuating due to economic cycles. The state of an economy depends on supply and demand and repeats the four cycles of upturn, boom, recession and depression. A cycle may last from two to 15 years and may have a different duration than other cycles. Countries and central banks may stimulate the economy through different measures and thus influence the state of an economy. This has an immediate effect on the value of the investor’s assets, especially on shares, bonds and currencies. For example, the investor may suffer a loss if the portfolio of bonds loses in value after interest rates are hiked up.
2.11 Liquidity Risk
The investor bears the risk of not being able to buy or sell assets at market prices at all times. This may lead to additional expenses and lower the margin of profit. In an illiquid market, the investor runs the risk of paying additional illiquidity premiums and of his/her purchase or sell orders only being executed after a delay, leading to possible financial losses.
2.3 Information Risk
The investor bears the risk of buying or selling assets based on incomplete, outdated or wrong information. This may lead to financial losses.
2.4 Psychological Risk
The investor bears the risk of suffering losses due to psychological effects. For example, this might happen if investors allow personal feelings or moods to influence their decisions and no longer make rational decisions. This may result in financial losses for the investor – especially when an investor is subject to such effects and therefore cannot perceive them due to subjectivity.
2.5 Tax Risk
The investor bears the risk of suffering a loss due to effects of taxation. Taxation may have an effect either on the personal wealth or on the financial instruments among the assets. For example, if a company in a foreign country has to pay more taxes in said country because the taxation framework has changed, this may lead to lower profits and possibly to a lower share price. The investor also has to pay taxes on capital gains and must adhere to the applicable rules. The investor should discuss the details with a tax consultant.
2.6 Risk of Expenses
The investor bears the risk of suffering a loss due to expenses in connection with the whole investment activity. This may even happen if the assets would yield a profit without considering the expenses. Such expenses are incurred when transactions are carried out, for having the account with a broker, payment of administrative fees to mutual funds, etc. The investor should obtain information about possible expenses before buying or selling assets in order to estimate the profitability of his/her actions over the whole investment period.
2.7 Risk despite Supervisory Control
The investor shall continue to bear the risks even if the instructed financial service providers are subject to supervisory control.
2.8 Leverage Risk
The investor bears the risk of suffering heavier losses in the case of credit-financed investments than in the case of investments not financed by credits. If the value of the assets decreases, the investor may no longer be able to post collateral or to make the payments on the interest and the principal of the credit, forcing the investor to sell (part of) the assets. We therefore generally advise against loan-financed investments. For investments, you should only use freely available capital that is not needed elsewhere.
3. Principles and Risks of different Types of Investments
For a company, issuing shares/stocks is an opportunity to raise the company’s equity capital. If an investor buys the company’s shares, he/she becomes a part owner of the company. There are different types of shares, either allowing the investor to influence the business of the company – or not. Before buying shares, the investor should check the rights and duties that come with the purchase.
As shareholder, the investor directly participates in the business success of a company. Therefore, the payments to be received from the shares theoretically depend on the dividends paid out and on the performance of the share price. In reality, the value of an investment in shares is however subject to additional risks, like the following: risk of price fluctuation, bankruptcy risk, dividend risk and risk of changing interest rates.
Historically, shares showed a return on investment of 8% per year on average, with a volatility between 15% and 30% per year. But past performance is no indicator for future performance of share prices because hitherto unknown factors and events may influence the future share price.
For a company, issuing bonds is an opportunity to raise the company’s debt capital. If an investor buys a company’s bonds, he/she does not become a part owner of the company. Instead, the investor credits a nominal amount to the company for a defined term. During this term, the company will pay the investor interest in regular intervals. At the end of the term, the company will return the nominal amount to the investor. As opposed to shares, bonds have a far wider range of features in practice, for example buy-back clauses. Before buying bonds, the investor should check the rights and duties that come with the purchase.
In theory, after issuing a bond, a company will make the previously defined payments to the investor. In reality, the value of an investment in bonds is subject to additional risks, like the following: bankruptcy risk, credit risk, inflation risk, risk of changing interest rates and risk of price fluctuation.
Historically, bonds have had a lower return than shares. Investments in bonds have also been less volatile. But past performance is no indicator for future performance bond prices, because hitherto unknown factors and events may influence future prices of bonds.
3 Risks of Open Mutual Funds and Index Funds
3.3 Risk of Loss
The investor bears the risk of a total or partial loss of the invested capital. This will happen, for example, if the value of the mutual fund or the index fund will drop and the investor sells shares at a price lower than the purchase price. This may lead to financial losses.
3.4 Tracking Risk
The investor bears the risk that the return of a mutual fund or an index fund will be below the return of the replicated index or the benchmark index because of administrative fees and other effects. This may lead to financial losses.
3.5 Index Risk
The investor bears the risk of the index, which serves as a benchmark to a mutual fund or the performance of which is supposed to be replicated by an index fund, being changed in its composition or calculation. The investor must also be aware of the risk of over- and under-representing specific companies in an index.
3.6 Closing-down Risk
The investor bears the risk of the mutual or index fund being closed down by the managing mutual fund company. In that case, the value of the mutual fund may be paid out to the investor. The investor thus bears an additional risk of loss and of solvency if the mutual fund company will close down one of its funds.
3.7 Transfer Risk
The investor bears the risk of a mutual or index fund being terminated by the managing mutual fund company or being transferred to another mutual fund provider. The investor thus bears all risks that may arise from the transfer, for example the index risk and the tracking risk.
3.8 Liquidity Risk
The investor bears the risk of a mutual fund company suspending the buy-back of fund shares.
3.9 Secondary Market Risk
The investor bears the risk that an index fund bought on the stock exchange will no longer be listed there or that trading will be made more difficult. This may limit the investor’s ability to sell the index fund at the time of his/her choice.
3.10 Risk of Securities Lending
The investor bears the risk of liquidity shortages by the mutual or index fund that may result from securities lending. The managing mutual fund company may lend specific assets of the mutual fund to other market players in order to generate additional returns for the investor. If several investors want to return their shares during a time of securities lending, this may lead to liquidity shortages because the lent securities cannot be sold by the mutual fund. The investor bears all risks resulting from securities lending to other market players.
3.11 Collateral Risk
In the case of synthetically replicated index fund, the investor bears all risks arising in case the swap counterparty of the managing mutual fund will fail. While swap counterparties must post collateral to back up the synthetically replicated swap deal, this collateral usually does not reflect the value of the replicated index and thus only provides vague security to the investor if a swap counterparty will fail. This may result in financial losses for the investor.
4. Risks of Trading with Securities
4.1 Transmission Risk
The investor bears all risks that arise from orders given to the investor’s financial services providers that were ambiguous or wrong.
4.2 Price Risk
The investor bears the risk of suffering losses due to price fluctuations between the placement of the order and the execution of the order.
4.3 Risk of Stock Exchange Measures
The stock exchange may suspend the trading of securities, for example in cases of high volatility. The resulting risks are borne by the investor.
5. Provider Risk
The investor bears all risks associated with placing an order with a broker. Besides the risks of trading with securities, this includes in particular conflicts of interest on behalf of the provider, which may cause financial losses to the investor. Among others, this includes sloppy adherence to regulatory requirements, recommending products with which the provider earns more money than with cheaper products, and information about the future performance of products which seems realistic and positive in order to convince the investor to buy the product. The investor is thus advised to obtain full information about the offered products and to take into account that price trends in financial markets are practically impossible to predict in many cases. In order to obtain a comprehensive picture of the current market situation and to avoid information risks, investors should gather comprehensive and different information before making an investment decision, preferably from several independent sources.
6. Risks of the Stress Test
6.1 Scenario Risk
The investor bears the risk that a scenario that he/she uses for the stress test will not materialize later. Although scenarios allow a view into the future, it remains more than uncertain if they will indeed become reality. Rather, it has to be assumed that it will become obvious ex-post that they showed a wrong image of reality. Even if scenarios are developed with the ambition of providing the best possible prognosis for the future development of the market based on the information currently available, it remains impossible to predict unexpected market movements. Therefore, scenarios have a purely hypothetical character.
6.2 Optimization Risk
The suggested optimization measures generated by the app are based on the investor’s information and on the selected scenario. As suggested optimization measures depend directly on the underlying scenario, they are subject to scenario risks. The investor bears the resulting optimization risk. The investor is recommended to check whether the suggested optimization measures make sense and to compare them with other suggestions before implementing them in full or in part.
6.3 Methodological Risk
The investor bears the risk that the calculation method provided by the stress test does not live up to the expectations of third parties and won’t be revealed. The calculation method is not up to further development in an open, academic discourse and is exclusively up to the knowledge and further development of the provider of the stress test.
6.4 Risk of Aggregation
The investor bears the risk of aggregating assets in shares, bonds and mutual funds which does not exactly correlate to their individual risks. This may lead to financial losses.
6.5 Risk of Incompleteness
The investor bears the risk of the held assets not being able to be reproduced in the stress test, meaning that the stress test is incomplete with regard to the investor’s assets. This may lead to financial losses.
6.6 Technological Risk and Risk of Hacking Attacks
The investor bears the risk of technological problems, interruptions in the connection or hacking attacks that may prevent the investor from carrying out the stress test.