Risk Overview
Before diving into specific risk types, you need a framework for how risk works in the securities industry.
What Is Risk?
- Risk is the possibility that an investment's actual return will differ from its expected return
- Every investment carries some degree of risk; there is no truly "risk-free" investment
- U.S. Treasury securities are considered the closest to risk-free, but they still carry inflation risk and interest rate risk
The Risk-Return Tradeoff
- Risk and return are positively correlated - higher potential return generally requires accepting higher risk
- Investors who want the safety of a savings account accept low returns
- Investors who want equity-like growth must accept the possibility of significant losses
Think of it this way: Risk and return are two sides of the same coin. A savings account feels safe, but inflation quietly eats away at your purchasing power. Stocks can grow your wealth faster, but the ride is bumpy. There is no shortcut that gives high returns without high risk.
- Understanding different risk types helps with matching investments to client objectives
Exam Tip: Gotchas
- The exam may present a "risk-free" investment. Even U.S. Treasuries carry inflation risk and interest rate risk. The only thing they are free of is credit (default) risk.
How Risk Types Connect
Investment risks fall into two broad categories that you will explore throughout this unit:
| Category | Also Called | Can Be Diversified? | Examples |
|---|---|---|---|
| Systematic risk | Market risk, non-diversifiable risk | No | Interest rate changes, inflation, recession |
| Non-systematic risk | Diversifiable risk, company-specific risk | Yes | CEO departure, product recall, lawsuit |
Memory Aid: PRIME (Systematic Risks)
- P - Purchasing power (inflation)
- R - Reinvestment risk
- I - Interest rate risk
- M - Market risk
- E - Exchange rate (currency) risk
All five are systematic - diversification cannot eliminate them.
Knowing which category each risk type belongs to is frequently tested; it determines which mitigation strategy applies.
Now that you have the big picture, let's examine each risk type, starting with the most fundamental: capital risk.