CISI IoI Investment Risk and Return — Questions and Answers
Question 1: What is the 'risk-return trade-off' in investing?
- Higher-risk investments always produce higher returns than lower-risk investments
- Investors generally expect higher potential returns from higher-risk investments to compensate for the greater uncertainty of outcome (Correct answer)
- Lower-risk investments provide no return at all
- All investments carry identical risk when held for more than 10 years
Correct 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.
Question 2: What is 'volatility' as a measure of investment risk?
- The risk that a company defaults on its bond payments
- The degree to which an investment's price fluctuates over time, typically measured by standard deviation of returns (Correct answer)
- The risk of inflation eroding the purchasing power of returns
- The risk that an investor needs to sell an investment at short notice at a poor price
Correct 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.
Question 3: What is 'credit risk' in the context of bond investing?
- The risk that interest rates rise, reducing the value of a bond
- The risk that the bond issuer defaults on its obligation to pay interest or repay principal (Correct answer)
- The risk that the bond cannot be sold quickly at a fair price
- The risk that inflation reduces the real value of the bond's income
Correct 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.
Question 4: What is 'liquidity risk'?
- The risk that a company runs out of cash to pay its bills
- The risk that an investor cannot sell an investment quickly at a fair price when they need to (Correct answer)
- The risk that interest rates change unexpectedly
- The risk that inflation exceeds the return on an investment
Correct 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.
Question 5: What is meant by 'diversification' as a risk management strategy?
- Investing all available capital in the single highest-returning asset class
- Spreading investments across different asset classes, sectors, and geographies to reduce the impact of poor performance in any single investment (Correct answer)
- Investing only in government bonds to eliminate credit risk
- Choosing investments with negative correlation to the FTSE 100
Correct 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.
Question 6: What is 'inflation risk' in the context of savings and investment?
- The risk that a company raises its prices excessively
- The risk that the return on an investment fails to keep pace with inflation, reducing the real purchasing power of the investor's wealth (Correct answer)
- The risk that interest rates rise faster than expected
- The risk that the government increases taxes on investment returns
Correct 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.
CISI IoI Investment Risk and Return
What is the 'risk-return trade-off' in investing?