Investment (Risk Tolerance) 3 — Questions and Answers
Question 1: Standard deviation is commonly used in investing to measure what?
- The volatility, or dispersion, of an asset's returns (Correct answer)
- The dividend yield of a stock
- The credit rating of a bond
- The liquidity of a fund
Correct answer: The volatility, or dispersion, of an asset's returns
Standard deviation quantifies how much returns vary, a core measure of risk.
Question 2: An aggressive investor with high risk tolerance would typically hold a portfolio weighted toward which allocation?
- A higher percentage of equities (Correct answer)
- A higher percentage of cash
- Mostly short-term CDs
- Entirely money market funds
Correct answer: A higher percentage of equities
Equities offer higher expected returns and volatility, fitting an aggressive, high-tolerance investor.
Question 3: Which of these life events would most likely DECREASE an investor's risk tolerance?
- Approaching retirement and needing income soon (Correct answer)
- Receiving a large, stable salary increase
- Paying off all debts
- Having a longer time horizon
Correct answer: Approaching retirement and needing income soon
Nearing retirement shortens the horizon and increases the need for capital preservation.
Question 4: The concept of 'risk-adjusted return' helps investors do what?
- Compare returns relative to the amount of risk taken (Correct answer)
- Eliminate all investment risk
- Guarantee a fixed return
- Avoid paying taxes
Correct answer: Compare returns relative to the amount of risk taken
Risk-adjusted return evaluates how much return was earned per unit of risk, enabling fair comparison.
Question 5: A 30-year-old investing for retirement at 65 can generally tolerate more risk because of which principle?
- Time diversification allows recovery from short-term losses (Correct answer)
- Stocks never decline over any period
- Younger investors pay no taxes
- Bonds always outperform stocks
Correct answer: Time diversification allows recovery from short-term losses
A long horizon lets short-term volatility average out, supporting greater equity exposure.
Question 6: Which behavioral bias can cause investors to MISJUDGE their true risk tolerance during a bull market?
- Overconfidence (Correct answer)
- Loss aversion during downturns
- Liquidity preference
- Tax-loss harvesting
Correct answer: Overconfidence
Rising markets often make investors overconfident, leading them to overestimate their tolerance for risk.
Question 7: An emergency fund covering 3–6 months of expenses primarily supports risk tolerance by doing what?
- Allowing investments to stay invested during downturns rather than being sold for cash (Correct answer)
- Guaranteeing higher stock returns
- Eliminating market volatility
- Replacing the need for diversification
Correct answer: Allowing investments to stay invested during downturns rather than being sold for cash
A cash cushion prevents forced selling, raising an investor's ability to ride out volatility.
Investment (Risk Tolerance) 3
Standard deviation is commonly used in investing to measure what?