According to the FINRA webiste, political and currency risks are under Market risks. Therefore, the correct answer and the explanation are wrong.
I understand how you’re reaching your conclusion, but we stand behind this question for a few reasons. First, the Series 65 is not a FINRA exam. It is written by the North American Securities Administrators Association (NASAA), and the two organizations have different perspectives on risk. Even so, we expect FINRA exams to test risks in the way we present them. I am quite certain the people writing the webpages on FINRA’s site are not the same people on the test writing board.
Beyond the background, let’s think about these risks. Currency - the risk of fluctuation in currency values negatively affecting an investment. While we live in a globalized world today, many publicly traded companies operate nearly 100% within American borders. When fluctuations in currency persist, these companies typically face little-to-no impact to their business. Therefore, it can be argued diversifying into investments with insignificant ties to foreign currencies does reduce this risk.
Political risk is not exactly the same as ‘sociopolitical risk’ cited on the FINRA page. Political risk as we believe it’s tested is investment risk due to government instability. Although we have our political problems in the US, we’ve generally had the same governmental structure for nearly 250 years. Therefore, we believe political risk is being tested as a foreign risk, especially applicable to third world countries. How can an investor avoid this risk? Diversify into investments not from these areas of the world.
Last thought - market risk can include a number of different scenarios, but one central theme exists. Market risk occurs when an event or circumstance is negatively impacting the general, broad market. Of the three risks mentioned in your post, I’d argue market risk is the most difficult to avoid through diversification. A decent number of test takers report encountering questions with multiple right answers. If this happens to you, choosing the “best” correct answer is required. Ask yourself - of the answers provided, which is most unlikely to be avoided through diversification? I’d argue market risk!
I hope this helps!
First, thank you for the explanation and especially for the difference in FINRA and NASAA. However, wouldn’t Currency and Political Risks similarly affect the portfolio as Maket risk does? In case of national currency (e.g USD) fluctuation, all assets will be affected in a similar way. Should government problems occur, all sectors will be affected then. They’re all difficult to avoid nor are they industry specific, should they happen. I don’t argue, I’m just trying to understand the logic in view of “drastically reducing exposure”.To me it’s more of a comparison, than a pure statement. If I could explain my idea.
Here’s the easiest way to think about it - both currency and political risk are considered risk factors for securities connected to foreign countries. In order for currency risk to be a factor, a business must be international (many US-based stocks have primarily domestic operations). Currencies strengthen and weaken in relation to other currencies. If a business only had operations and customers in the US (utilizing the US Dollar), currency risk would not be a significant concern. Political risk relates to instability of a governmental structure, and we haven’t experienced a coup, throwover of government, or anything similar since the 18th century. However, we’re seeing great government instability in places like Ukraine today, and therefore would apply to risk to companies connected to Ukraine.
Market risk is more of a category of risk that encompasses any event or circumstance that drives the general market downward. Think about recent real world examples of market risk:
- 2022 inflation / economic distress
- 2020 introduction of COVID
- 2008 housing crisis
- 2001 tech bubble
Last Thursday, May 5th was a really good example of market risk:
As you can see, nearly every stock is in the red. The culprit? Inflation and a weakening economy. Generally speaking, we have not encountered days like this due to currency fluctuations or government instability.
One last thought - I think you’re getting wrapped up in possibilities. Could the US Dollar significantly weaken and cause a general market crash? Yes. However, currency fluctuations typically rattle small sectors of the market - in particular, those that are consistently engaging in currency exchanges. Same with political risk. Would the market look like this if the US Government was overthrown? Yes. But, we generally don’t expect that to happen. You could find a similarity with default risk. Could the US Government default on its debt? Of course, but we generally say Treasury securities have virtually no default risk because of real world expectations.
Exactly what I meant. The fact that we haven’t had them (and I hope we won’t) shouldn’t change their core:
When an event or circumstance negatively affects the overall market, it’s known as a type of systematic risk
This is not a possibility but a relativity question. If we start relating this to markets abroad, then such risks become company specific and, therefore, can be diversified. I got this point. Again, thank you for such a detailed explanation!