Investment Risks
About This Lesson
Risk is less a standalone topic than a lens the SIE applies to everything else you have studied. The exam rarely asks you to calculate risk; far more often it describes a situation and asks you to name the risk at work, or to say whether diversification would help. Master one organizing idea, the split between systematic and non-systematic risk, and the rest of the chapter falls into place.
What you'll cover
- the full catalog of risk types and how to recognize each by description
- the systematic-versus-non-systematic split and what diversification can and cannot fix
- matching common exam scenarios to the right risk
- measuring risk with beta and alpha, and the limits of diversification
This is the tenth chapter of the products module.
Types of Investment Risk
Risk takes many forms, and the SIE expects you to recognize each one by its description. The full catalog worth knowing:
- Market (systematic) risk: the whole market declines, the one risk you cannot diversify away.
- Business (non-systematic) risk: trouble specific to one company or industry, which diversification can reduce.
- Credit (default) risk: a bond issuer fails to make interest or principal payments.
- Interest-rate risk: rising rates push existing bond prices down.
- Reinvestment risk: income has to be reinvested at lower rates than the original.
- Inflation (purchasing-power) risk: returns fail to keep pace with rising prices, the classic threat to fixed income.
- Liquidity risk: an investment cannot be sold quickly at a fair price.
- Currency (exchange-rate) risk: a stronger dollar erodes the value of foreign holdings when they are converted back.
- Political/legislative risk: government action, new regulation, instability, or nationalization, hurts an investment.
- Prepayment risk: mortgages behind an MBS refinance early when rates fall, returning principal sooner than expected.
- Capital risk: the chance of losing some or all of the original investment.
An investor holds an international stock fund. The fund's holdings increase 8% in value in local currency, but the U.S. dollar strengthens significantly against those currencies. The investor's actual return in USD will most likely be:
Systematic vs Unsystematic Risk & Diversification
Systematic (market) risk affects the ENTIRE market, you cannot diversify it away. Examples: interest rate changes, inflation, recession.
Non-systematic risk affects specific companies/industries, it CAN be reduced through diversification. Examples: management failure, product recalls, lawsuits.
Risk cannot be eliminated, but it can be managed. The SIE expects three mitigation tools:
- Diversification: spreading money across different asset classes, sectors, and geographies, which reduces non-systematic risk but does nothing for market risk.
- Portfolio rebalancing: periodically resetting the asset allocation back to its target weights.
- Hedging: using options or other instruments to offset potential losses.
The exam loves to describe a situation and ask which risk it illustrates. This mapping covers the scenarios you are most likely to see:
| Scenario | Primary Risk |
|---|---|
| Overall stock market declines | Market (systematic) risk |
| A single company's stock drops on bad earnings | Business (non-systematic) risk |
| Bond issuer misses interest payments | Credit (default) risk |
| Interest rates rise, bond prices fall | Interest rate risk |
| Bond is called early, reinvest at lower rate | Reinvestment risk |
| Investment returns don't keep up with rising prices | Inflation (purchasing power) risk |
| Can't sell a DPP or thinly traded stock quickly | Liquidity risk |
| Foreign stock gains erased by exchange rate change | Currency (exchange rate) risk |
| New government regulations hurt an industry | Legislative (political/regulatory) risk |
| Mortgages refinanced early, MBS principal returned | Prepayment risk |
| Bond's credit rating downgraded | Credit (downgrade) risk |
Which type of risk can be reduced through diversification?
Which of the following risks can be reduced through diversification?
Measuring Risk: Alpha, Beta & MPT
The SIE tests a few basic measures of portfolio risk and return.
Beta
Beta measures a security's volatility relative to the market, and it captures systematic risk only. A beta of 1.0 moves with the market; above 1.0 is more volatile (a beta of 1.5 swings 50% more than the market); below 1.0 is less volatile. The math is direct: a stock with a beta of 1.8 would be expected to rise about 18% when the market rises 10%.
Alpha
Alpha measures a portfolio's return above or below what its risk level would predict. Positive alpha means it outperformed that benchmark; negative alpha means it lagged.
The diversification principle
Adding securities that are not perfectly correlated lowers a portfolio's overall risk. But diversification only erases non-systematic risk; it cannot touch systematic (market) risk. The more names you add, the closer the portfolio's risk settles toward pure market risk, and no further.
A stock has a beta of 1.8. If the overall market rises 10%, this stock would be expected to:
Chapter Essentials
Every risk on the exam sorts into one of two buckets. Systematic (market) risk hits the entire market, interest-rate, inflation, and recession risk, and cannot be diversified away. Non-systematic risk is specific to a company or industry, business, credit, and liquidity risk, and diversification can reduce it. That single split is the most-tested idea in the chapter.
Beyond it, recognize the individual risks by description: rising rates mean interest-rate risk, an issuer missing payments is credit risk, a thinly traded holding is liquidity risk, and a foreign position hurt by a stronger dollar is currency risk. On measurement, beta gauges volatility against the market (a beta of 1.8 moves 1.8 times as much), alpha is return above expectations, and diversification drives a portfolio's risk down toward, but never below, market risk.
All risk types and their product associations on a single reviewable page.
The reliable gotchas in this chapter:
• Only non-systematic risk diversifies away. Diversification reduces company- and industry-specific risk (business, credit, liquidity), but market, interest-rate, and inflation risk are systematic and stay no matter how many names you hold.
• Match the scenario to the risk. Rising rates is interest-rate risk, a missed payment is credit risk, an unsellable holding is liquidity risk, and a foreign gain erased by exchange rates is currency risk.
• Beta multiplies the market move. A beta of 1.8 means roughly 1.8 times the market's return, so a 10% market gain implies about an 18% move. Beta affects size, not direction.
• Inflation risk targets fixed income. Bonds and other fixed payments are the most exposed to purchasing-power risk, because their cash flows do not rise with prices.
• Diversification has a floor. Adding uncorrelated securities lowers risk only down to the level of systematic market risk; it cannot remove that last layer.
Test yourself with exam-style questions on this topic.