Investment Risk and Return Flashcards

What is the 'risk-return trade-off' in investing?

Answer: Investors generally expect higher potential returns from higher-risk investments to compensate for the greater uncertainty of outcome

The risk-return trade-off reflects the principle that investors require higher expected returns to compensate for taking on greater risk. There is no guarantee of higher returns with higher risk, but rational investors demand a higher expected return as compensation.

What is 'volatility' as a measure of investment risk?

Answer: The degree to which an investment's price fluctuates over time, typically measured by standard deviation of returns

Volatility measures how much an investment's price moves up and down over time. It is commonly measured by the standard deviation of historical returns — the higher the standard deviation, the greater the volatility and the higher the risk.

What is 'credit risk' in the context of bond investing?

Answer: The risk that the bond issuer defaults on its obligation to pay interest or repay principal

Credit risk (also called default risk) is the risk that the issuer of a bond fails to make the promised coupon payments or to repay the principal at maturity. Corporate bonds carry higher credit risk than UK gilts.

What is 'liquidity risk'?

Answer: The risk that an investor cannot sell an investment quickly at a fair price when they need to

Liquidity risk is the risk of being unable to convert an investment into cash quickly without accepting a significant discount to its fair value. Some assets — such as property or AIM shares — have lower liquidity than FTSE 100 shares.

What is meant by 'diversification' as a risk management strategy?

Answer: Spreading investments across different asset classes, sectors, and geographies to reduce the impact of poor performance in any single investment

Diversification reduces portfolio risk by spreading investments so that poor performance in one area is offset by better performance elsewhere. A well-diversified portfolio is less volatile than a concentrated one because not all assets move in the same way at the same time.

What is 'inflation risk' in the context of savings and investment?

Answer: The risk that the return on an investment fails to keep pace with inflation, reducing the real purchasing power of the investor's wealth

Inflation risk (or purchasing power risk) means that even if a nominal return is positive, if inflation is higher than the return, the investor's real (inflation-adjusted) wealth has fallen. Cash savings accounts often suffer from inflation risk.