Investment Risks and How to Manage Them

Section 2 of the exam is 44% of your score, and risk runs through all of it. Most risk items give you a short scenario and ask you to name the risk. This lesson gives you the eleven named risks, the products that carry each one, and the three ways to cut risk down.

Two families of risk

Every risk here belongs to one of two families, and the family decides whether diversification helps.

Systematic risk comes from the whole market. A recession, a rate shock, or a war moves nearly every security at once. Diversification does not remove it, because buying more stocks buys more of the same market. Beta measures how much a security's price moves when the market moves, so beta puts a number on systematic risk.

Non-systematic risk comes from one company or one industry. A factory fire or a lost lawsuit hits one issuer and leaves the rest of the market alone. Diversification does remove it, which is why the exam also calls it diversifiable risk.

The eleven named risks

Learn each risk by its trigger, because the exam describes the trigger and asks for the name.

• Market risk (systematic risk): the whole market drops and your holding drops with it. A recession takes the market down 20%, and your fund falls too.
• Non-systematic risk: one issuer stumbles while the market holds up. A recall sinks one carmaker's stock on a flat day.
• Capital risk: you lose part or all of the money you put in. You buy at $40, the company fails, and the shares end at zero.
• Credit risk (default risk): the issuer stops paying interest or principal. A BB-rated issuer misses a coupon. Ratings below BBB-/Baa mark high-yield, or junk, bonds.
• Interest rate risk: market rates rise and bond prices fall. You own a 30-year bond paying 4%, new bonds pay 6%, and yours now sells at a discount. Longer maturities move more.
• Reinvestment risk: rates fall and you must put your income back to work at a lower rate. Your 6% bond matures and the best new bond pays 4%.
• Prepayment risk: homeowners repay their mortgages early, usually after rates fall, and your high-rate income ends. A mortgage-backed security returns principal fast in a refinancing wave. A callable bond carries the same problem under the name call risk.
• Inflation risk (purchasing power risk): prices rise faster than your fixed income. Your bond pays 3% while inflation runs 4%, so each payment buys less.
• Liquidity risk: you cannot sell at a fair price when you want to. A limited partnership interest has no ready market, so you sell at a steep discount or wait.
• Currency risk: an exchange rate move changes your return on a foreign holding. An ADR (American Depositary Receipt) is a U.S.-traded receipt for shares of a foreign company. The home currency falls 10% against the dollar and your ADR loses about 10%, with the foreign share price flat.
• Political risk: government action or instability cuts your return. A country blocks money from leaving or takes over an industry.

Which products carry which risks

Questions often name a product and ask which risk fits. Learn the pairings.

• Common stock: capital risk, market risk, and non-systematic risk.
• Corporate bonds: credit risk, interest rate risk, reinvestment risk, and inflation risk. A callable issue adds call risk.
• Treasury securities: interest rate risk, reinvestment risk, and inflation risk. The exam treats Treasuries as free of credit risk. TIPS adjust their principal with the Consumer Price Index, so they answer inflation risk.
• Municipal bonds: credit risk, interest rate risk, and liquidity risk, because many issues trade thinly.
• Mortgage-backed securities and CMOs (collateralized mortgage obligations, bonds backed by a pool of mortgages): prepayment risk on top of interest rate risk.
• Foreign stock and ADRs: currency risk and political risk, on top of the usual stock risks.
• DPPs, non-traded REITs, and hedge funds: liquidity risk, because no ready market exists.
• Money market instruments: inflation risk, because the yield is low.

Three ways to cut risk down

Diversification spreads money across issuers, industries, and asset classes. It removes non-systematic risk and leaves market risk untouched. One mutual fund gives a small investor instant diversification, because the fund holds many issuers. Most of the benefit arrives by about 30 positions.

Portfolio rebalancing returns a portfolio to its target mix. Say you set 60% stocks and 40% bonds, and a strong year pushes stocks to 70%. You sell stocks and buy bonds until the mix reads 60/40 again. Rebalancing trims risk that grew by accident.

Hedging takes a second position that gains when your main holding loses. You own 100 shares and buy one put on the same stock. The stock falls, the put gains, and the put limits your loss. That pairing is a protective put. Hedging needs positions that move in opposite directions, which is what separates it from diversification.

How this gets tested

Read the direction of interest rates first, because two triggers do most of the work. Rates up points to interest rate risk and a falling bond price. Rates down points to reinvestment risk, call risk, or prepayment risk.

The exam also tests the limit of diversification. A question that adds 50 more stocks and asks what risk remains wants market risk.

A sample of the logic: an investor holds a mortgage-backed security, and mortgage rates drop two points. Which risk shows up? Prepayment risk. Homeowners refinance, the principal comes back early, and the investor reinvests it at a lower rate.