Investment Risks

Systematic and unsystematic

Systematic risk affects the whole market and cannot be diversified away. Holding more different stocks does not help, because they all fall together. It is hedged rather than diversified — with index puts, or by moving to a different asset class.

The systematic risks:

Market risk — the risk that the whole market declines.

Interest rate risk — the risk that rising rates reduce the value of existing fixed-rate holdings. It is the dominant risk in long-dated, low-coupon bonds.

Inflation risk, also called purchasing power risk — the risk that returns fail to keep pace with prices. It is the specific risk of holding cash and short-term fixed income for long periods, and it is what a retiree who moves everything into money market instruments has traded market risk for.

Unsystematic risk is specific to an issuer or an industry and can be diversified away by holding many different issuers.

The unsystematic risks:

Business risk — the risk that a particular company performs badly.

Credit or default risk — the risk that an issuer fails to pay interest or principal. Rated by the agencies, and effectively absent from Treasury securities.

Regulatory or legislative risk — the risk that a change in law or regulation damages a particular industry.

Political or country risk — the risk arising from instability in a foreign issuer's home country, which is one of the risks specific to ADRs.

Currency or exchange rate risk — the risk that a foreign currency moves against the dollar, reducing the dollar value of a foreign holding.

The other named risks

Several risks do not fit the two-group split cleanly and are worth their own list.

Liquidity or marketability risk — the risk that a holding cannot be sold quickly at a fair price. It is the defining risk of non-traded REITs, direct participation programs, hedge funds, thinly traded municipal bonds and auction rate securities.

Call risk — the risk that an issuer redeems a bond early, which happens when rates fall and the holder would rather keep the high coupon. Callable bonds and preferred stock carry it.

Reinvestment risk — the risk that cash returned must be reinvested at lower rates. It follows a call, and it is inherent in any coupon-paying bond. Zero-coupon bonds are the exception: with no coupons to reinvest, they have none, which is why a zero is the answer for funding a known future obligation on a known date.

Prepayment risk — the mortgage-backed version of the same thing, where homeowners refinance and return principal early. Its mirror is extension risk, where slowing prepayments lengthen the security's life just as rates rise.

Timing risk — the risk of entering or exiting at an unfavourable moment.

Capital risk — the risk of losing the principal invested, which is the basic risk of any equity or non-guaranteed instrument.

Opportunity cost — the return given up by choosing one investment over another, which the outline treats as a consideration rather than a hazard.

Defences, and what beta measures

Each risk has a characteristic response, and knowing the pairing answers the exam's matching questions directly.

Market risk: hedge with index options, or diversify across asset classes rather than within one.

Interest rate risk: shorten maturities, hold floating-rate instruments, or ladder maturities so reinvestment is spread over time.

Inflation risk: TIPS, and equities over long horizons.

Business and credit risk: diversify across issuers, and buy higher-rated issuers.

Liquidity risk: avoid illiquid products where the customer may need the money, and size any position in one to what the customer can leave alone.

Call risk: buy bonds with call protection, or accept a lower coupon on non-callable debt.

Reinvestment risk: zero-coupon instruments for a known future need.

Currency risk: currency options, or domestic holdings.

Beta measures a security's or a portfolio's volatility relative to the market. A beta of 1.0 moves with the market, above 1.0 more, below 1.0 less. It measures systematic risk only — so a highly concentrated portfolio can have a modest beta and still carry enormous unsystematic risk, which is precisely why beta is not a complete risk measure and why the exam pairs it with diversification questions.

One standing principle across all of this: the appropriate response to a risk depends on the customer's profile, not on the risk being bad in itself. A young investor with decades to retirement can accept market risk and should worry about inflation risk; a customer needing the money in a year should worry about the opposite.