Investment Risk and Return Flashcards

What is 'market risk' (also called systematic risk)?

Answer: The risk inherent to the entire market that cannot be eliminated through diversification, such as recessions or interest rate changes

Systematic (market) risk affects the whole market and cannot be diversified away. Examples include macroeconomic shocks, interest rate changes, and recessions. In contrast, unsystematic (specific) risk relates to individual companies and can be reduced through diversification.

What is the relationship between risk and time horizon in investing?

Answer: Longer time horizons generally reduce risk because short-term volatility smooths out over time, and investors have more time to recover from market downturns

Over longer time periods, markets have historically recovered from downturns. Investors with a long time horizon can afford to hold higher-risk assets, knowing they have time to wait for recoveries. Short-term investors cannot afford significant capital loss.

What is 'currency risk'?

Answer: The risk that changes in exchange rates reduce the value of foreign investments when converted back to the investor's home currency

Currency risk affects investors holding foreign-denominated assets. If the foreign currency weakens against sterling, the value of the investment when converted back to GBP falls, even if the investment has performed well in local currency terms.

What is 'counterparty risk'?

Answer: The risk that the other party to a financial contract defaults on their obligations

Counterparty risk is the risk that the person or institution on the other side of a financial transaction (a counterparty) fails to meet their contractual obligation. It is particularly relevant in derivatives and over-the-counter (OTC) transactions.

What does a 'risk profile questionnaire' assess?

Answer: The client's attitude to risk, capacity for loss, and time horizon, helping to determine the appropriate level of investment risk

A risk profile questionnaire gathers information about a client's attitude to investment risk (how they feel about potential losses), their capacity for loss (how much they could afford to lose without hardship), and their time horizon, enabling the adviser to recommend suitably matched investments.

What is 'concentration risk'?

Answer: The risk of having too large a proportion of a portfolio in a single investment, sector, or asset class, so that poor performance in that area has a disproportionate impact

Concentration risk arises when a portfolio is overly weighted towards a single stock, sector, geography, or asset class. Poor performance in that concentrated area will have a disproportionately large negative impact on the overall portfolio.