Types of Investment Risk
Quick Answer
Function 3.3 names five investment risks: call risk (callable bonds redeemed early), systematic risk (market-wide, undiversifiable), nonsystematic risk (issuer or sector specific, diversifiable), reinvestment risk (lower rates on reinvested cash flows), and timing risk (buying at peaks or selling at troughs). Adjacent risks include interest-rate, credit, inflation, liquidity, and legislative risk. Reg BI requires matching risk profile to customer needs.
With the disclosure framework set, the next input is the risk content of the disclosure. Function 3.3 names five risks by name, and the Series 6 candidate must know each one plus a handful of adjacent risks that travel with investment-company and variable-contract products.
What are the five investment risks named in Function 3.3?
| Risk | Definition | Series 6 Products Most Affected |
|---|---|---|
| Call risk | Risk that a callable bond or preferred stock is redeemed early by the issuer (typically when rates fall), forcing the investor to reinvest at lower yields | Bond funds holding callable corporate, municipal, or agency bonds; variable-annuity fixed-rate sub-accounts holding callable debt |
| Systematic risk | Market-wide risk affecting all securities in an asset class (interest-rate risk, inflation risk, broad market risk); cannot be diversified away | All equity and bond funds; variable-annuity sub-accounts; 529-plan investment portfolios |
| Nonsystematic risk | Risk specific to a single issuer, sector, or region (company-specific risk, industry risk, country risk); can be reduced by diversification | Single-stock or single-issuer exposure inside a fund; sector and country funds; concentrated positions in a variable-annuity sub-account |
| Reinvestment risk | Risk that cash flows (interest or matured principal) must be reinvested at a lower prevailing rate than the original investment | Bond funds distributing interest; mutual funds after capital-gain or dividend distributions; maturing certificates of deposit (CDs) in money market funds |
| Timing risk | Risk of purchasing at a market peak or selling at a trough; the risk that the timing of entry or exit diminishes returns | All open-end funds; variable-annuity lump-sum premium contributions; 529-plan lump-sum contributions (mitigated by dollar-cost averaging (DCA)) |
Exam Tip: Gotchas
- Diversification reduces nonsystematic risk only. A portfolio of 500 U.S. equity funds still suffers in a broad market decline. A customer worried about "the market dropping" has a systematic-risk concern; a customer worried about "one company failing" has a nonsystematic-risk concern.
- Call risk hurts the investor when interest rates fall. The issuer redeems the high-coupon bond, and the investor reinvests at the new lower rate. Callable bonds typically pay a higher yield to compensate for this risk.
- Timing risk is the principal risk DCA is designed to address. A customer making a large lump-sum variable-annuity or 529 contribution near a market peak bears maximum timing risk; periodic contributions spread the entry price over multiple Net Asset Values (NAVs).
What other investment risks apply to Series 6 products?
Beyond the five named risks, the Series 6 outline tests several adjacent risks that apply directly to investment-company and variable-contract products.
- Interest-rate risk: a specific form of systematic risk; bond prices move inversely to interest rates. Longer-duration bond funds are more sensitive. Applies to fixed-rate variable-annuity sub-accounts holding bonds
- Credit (default) risk: nonsystematic; the risk that a bond issuer fails to pay. Highest in high-yield (junk) bond funds; lowest in Treasury funds
- Inflation (purchasing-power) risk: systematic; the risk that inflation erodes real returns. Highest in money market and short-duration bond funds; lowest in equity funds over long horizons
- Liquidity risk: the risk that an investment cannot be sold quickly at a fair price. Affects closed-end funds trading at discounts, interval funds with quarterly repurchase limits, and variable annuities during the surrender period
- Legislative (political) risk: systematic; the risk that law or regulation changes adversely affect the investment. Notable for municipal bond funds (tax-law changes) and variable annuities (tax-deferral treatment)
Real-world example: A long zero-coupon Treasury bond has maximum interest-rate risk (long duration) but zero reinvestment risk during its life (there are no coupon payments to reinvest). The two risks are not the same direction: falling rates hurt reinvestment income but help existing bond prices.
Exam Tip: Gotchas
- Reinvestment risk and interest-rate risk move in opposite directions. Falling rates create reinvestment risk (new cash flows earn less) but help existing bond prices (price appreciation).
- Liquidity risk spikes during the surrender period of a variable annuity. A customer who liquidates in year 3 of a 7-year surrender schedule pays a stiff back-end charge even if the underlying sub-account is perfectly liquid.
- Legislative risk is the systematic-risk ceiling for municipal bond funds. A tax-law change that lowers ordinary-income rates or eliminates the federal exemption erodes the entire tax advantage that drives demand for munis.
The Representative's Obligation to Match Risk to the Profile
Risk disclosure ties back to suitability and Reg BI.
- Under Reg BI and FINRA Rule 2111, the rep must have a reasonable basis to believe the recommended product's risk profile is consistent with the customer's risk tolerance, time horizon, and liquidity needs
- Material risks must be disclosed in general terms so the customer can make an informed decision
- The rep does not need to quantify risk precisely, but must ensure the customer understands the principal risks the product carries
- The Function 3.1 suitability analysis (customer-specific factors) and the Function 3.3 risk disclosure are two sides of the same coin: one filters products through the profile; the other communicates the remaining risks in plain terms
Exam Tip: Gotchas
- Risk disclosure is a general-terms obligation, not a quantitative one. The rep does not owe the customer a beta or a standard deviation. The rep owes the customer an understandable description of what could go wrong.
- Reg BI layers on top of Rule 2111. For a retail customer, both apply. A recommendation that satisfies Rule 2111's reasonable-basis, customer-specific, and quantitative prongs still must satisfy Reg BI's Care, Disclosure, Conflict, and Compliance obligations.