Investment Risk Flashcards
Excluding systemic and non-systemic risks, Identify and briefly describe six types of investment risks that are currently faced by Alan and Lydia in their investment portfolio
Inflation risk-The risk that spending power of an asset will be eroded by inflation
Political/Taxation risk- The risk that a new or changed government will have different fiscal and monetary objectives to the previous one, including a decision to make major changes to the taxation system
Default / provider risk- The risk that a company may not be able to pay back the money invested
Operational risk- The risks that arise from the investment process, such as fraud, systems failure, trading errors and regulatory risk
Diversification risk / lack of diversification- The risk that too much is held in one asset/asset class
Interest risk- The risk that falls in rates could reduce the interest on savings. Rises in rates could impact of fixed interest yields.
Event risk- Specific event e.g. earthquake/tsunami, can affect performance
Currency risk- The risk that investments held in a foreign currency will be subject to fluctuations in exchange rates as well as market risk
State five benefits and five drawbacks of using a risk profiling tool to assess Alan and Lydia’s attitude to risk (10)
Benefits
Benefits
• Simple / understandable / consistent / repeatable process / objective
• Helps the client to understand/consider risk
• Separate risk profile for each client / objective established / attitude to risk can change
over time
• Assist with appropriate asset allocation
• Identifies the maximum loss tolerance / risk and reward
State five benefits and five drawbacks of using a risk profiling tool to assess Alan and Lydia’s attitude to risk (10)
Drawbacks
Drawbacks
• Clients may not understand the terminology / questions
• Adviser may misinterpret the results / different tools give different results
• May not establish capacity for loss
• Different objectives / clients may have different attitude to risk / may not consider
timeframe
• May not take into consideration their investment experience / behavioural finance /
emotion
• Cannot be used in isolation / further discussion needed
Having recently completed a risk profile questionnaire, Alan and Lydia are still unsure about how much investment risk they should take due to their recent change in employment status. Identify the main factors you should discuss with them in order to establish and agree their risk profiles.
• Need to understand their capacity for loss / how much of a loss they could bear without jeopardising their objectives / lifestyle
• Longevity / health
• Other income / capital available
• Ability to provide investments to match individual ATR noting views might differ
• Income needs / capital expenditure plans to assist in deciding whether they already hold
enough assets to meet their future needs and so whether focus should be on capital
preservation
• Timescale of investment
• How much of their capital are they prepared to put at risk / how much to keep in a secure
area
• Assess the above separately for different objectives
• Ensure they understand the risk characteristics of the selected investments
• Discuss volatility / explain investments can rise and fall
• Explain that risk is a feature of all asset classes e.g. inflation risk of holding cash, FSCS risk
• How much risk do they need to take / what investment return is required to achieve
objectives
• Their previous investment experience / knowledge
Comment briefly on the diversification within Alan and Lydia’s current savings and investment portfolio and identify whether the portfolio meets their risk profiles
- Cash holdings are excessive (62.5%) although a reasonable emergency fund is required due to some of these funds being required to provide income whilst the new business is being established
- The high level of cash holdings does not match their attitude to risk (ATR) profiles of adventurous for both of them
- They have a lack of diversification of asset classes, specifically property, fixed interest and alternative asset classes
- Equity asset allocation is not in line with their adventurous ATR, although Lydia’s Global Growth funds may mitigate some of this misalignment
- The asset allocation and risk rating of Alan’s UK Sustainable Growth fund within his stocks and shares ISA is not known, although this is likely to be a higher risk fund which will be more in line with his adventurous risk profile
- They have a low capacity for loss so cannot tolerate significant volatility within their overall portfolio
(i) Excluding systemic and non-systemic risks, Identify and briefly describe six types of investment risks that are currently faced by Alan and Lydia in their investment portfolio (12)
(ii) Explain how each of these risks you have identified in (i) above apply to Alan and Lydia
Inflation risk- The risk that spending power of an asset will be eroded by inflation
Political/Taxation risk - The risk that a new or changed government will have different fiscal and monetary objectives to the previous one, including a decision to make major changes to the taxation system
Default / provider risk- The risk that a company may not be able to pay back the money invested
Operational risk - The risks that arise from the investment process, such as fraud, systems failure, trading errors and regulatory risk
Diversification risk / lack of diversification - The risk that too much is held in one asset/asset class
Interest risk - The risk that falls in rates could reduce the interest on savings. Rises in rates could impact of fixed interest yields.
Event risk - Specific event e.g. earthquake/tsunami, can affect performance
Currency risk - The risk that investments held in a foreign currency will be subject to fluctuations in exchange rates as well as market risk
