Free CISI IRT Practice Questions: Principles of Investment Risk and Return

Use this focused CISI IRT page as a short practice test for Principles of Investment Risk and Return. The items are original Finance Prep sample exam questions built for scenario-based practice, not trivia, puzzle questions, official CISI questions, copied live-exam content, or exam dumps.

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These are original Finance Prep practice questions aligned to this topic area. They are not official CISI questions, copied live-exam content, or exam dumps. Use them to preview question style and explanation depth before continuing with topic drills, mixed sets, and timed mock exams in Finance Prep.

Question 1

Topic: Principles of Investment Risk and Return

In portfolio analysis, what does the Sharpe ratio measure?

• A. Excess return over the risk-free rate per unit of total volatility, usually measured by standard deviation.
• B. Return generated per unit of market risk, measured by beta.
• C. Excess return over a benchmark per unit of tracking error.
• D. Excess return over the risk-free rate per unit of downside deviation only.

Best answer: A

What this tests: Principles of Investment Risk and Return

Explanation: The Sharpe ratio is a risk-adjusted return measure. It shows how much excess return an investment or portfolio has produced above the risk-free rate for each unit of total risk taken. In this context, total risk is represented by standard deviation, which captures volatility of returns around their average. A higher Sharpe ratio generally indicates better compensation for volatility, although it should be compared with similar investments and over a suitable period. It differs from measures that focus only on market risk, benchmark-relative risk, or downside risk.

• Return per unit of beta describes the Treynor ratio, which uses systematic market risk rather than total volatility.
• Excess return over a benchmark per unit of tracking error describes the information ratio.
• Downside deviation is used in the Sortino ratio, not the Sharpe ratio.

The Sharpe ratio compares a portfolio’s risk premium with its total risk, using standard deviation as the risk measure.

Question 2

Topic: Principles of Investment Risk and Return

An adviser is reviewing a client’s ISA portfolio. The client’s attitude to risk and capacity for loss remain medium. The client asks whether to switch into a specialist fund because it had the highest recent return.

What is the best next step in the review process before making a recommendation?

• A. Discuss how the specialist fund’s higher return is offset by higher volatility, lower risk-adjusted return and weaker diversification benefit, then assess suitability against the client’s risk profile.
• B. Recommend the broad global equity fund immediately because its lower correlation guarantees that the client’s portfolio risk will fall.
• C. Recommend the specialist fund because its 12-month return is higher than the broad global equity fund’s return.
• D. Ask the platform provider to decide which fund is suitable because it supplies the performance and risk data.

Best answer: A

What this tests: Principles of Investment Risk and Return

Explanation: Recent return alone is not enough to justify a fund switch. Standard deviation indicates volatility: the specialist fund has fluctuated much more than the broad global equity fund. The Sharpe ratio gives a risk-adjusted view: here, the broad global equity fund has delivered more return per unit of risk. Correlation shows how closely the fund may move with the client’s existing portfolio: the specialist fund’s high correlation suggests limited diversification benefit. In a review, the adviser should interpret these measures, explain the trade-off to the client and assess whether the investment remains suitable for the client’s attitude to risk and capacity for loss before making a recommendation.

• A higher recent return can be attractive, but it skips the volatility, correlation and risk-adjusted return evidence.
• Lower correlation may improve diversification, but it does not guarantee that total portfolio risk will fall in every case.
• A platform provider may supply data, but the adviser remains responsible for assessing suitability and making the recommendation.

The figures show the specialist fund has more volatility, a lower Sharpe ratio and a high correlation with the existing portfolio, so suitability should be assessed before any switch.

Question 3

Topic: Principles of Investment Risk and Return

A retail investment firm is reviewing a study of UK equity-market efficiency. Assume dealing costs must be deducted before deciding whether an abnormal return is exploitable, and that returns between -0.2% and +0.2% are not economically meaningful.

Which conclusion about the Efficient Markets Hypothesis is best supported?

• A. Weak form is contradicted because the past-price rule has a positive gross return, while semi-strong and strong forms are supported.
• B. Semi-strong form is contradicted because prices moved when earnings announcements became public, while weak form is not tested.
• C. Weak and semi-strong forms are not contradicted, but strong form is challenged by the inside-information result.
• D. Strong form is supported because public announcements were absorbed quickly, while weak form is contradicted after costs.

Best answer: C

What this tests: Principles of Investment Risk and Return

Explanation: Weak-form EMH says past price information should not allow investors to earn abnormal returns after costs. Here, the chart-based rule has a gross abnormal return of +0.4% but costs of 0.5%, giving a net abnormal return of -0.1%, so it is not exploitable. Semi-strong-form EMH says publicly available information should be reflected quickly in prices. A large announcement-day price move is not a problem for this form; what matters is whether investors can profit after the information is public. The +0.1% later return is immaterial under the stated threshold. Strong-form EMH goes further and says even private information would not allow abnormal profits. The +3.5% return from non-public takeover information challenges that stronger claim.

• Treating the +0.4% chart-rule return as profitable ignores dealing costs, which turn it into a -0.1% net abnormal return.
• A price jump when earnings news becomes public is consistent with semi-strong efficiency if later abnormal returns are not exploitable.
• Quick absorption of public information does not support strong-form efficiency, because strong form also covers non-public information.

The past-price rule loses 0.1% after costs and the post-announcement drift is immaterial, while private information producing +3.5% abnormal returns conflicts with strong-form efficiency.

Question 4

Topic: Principles of Investment Risk and Return

A client can invest £20,000 either now or in 10 years’ time. In both cases, the investment would be held in the same fund, with the same expected annual return and all income reinvested. Which principle best explains why investing now is expected to produce a higher value at the end of 25 years?

• A. Diversification, because holding the fund for longer reduces exposure to market risk completely
• B. Pound-cost averaging, because the same lump sum is spread across different purchase dates
• C. Compounding, because returns earned early can themselves generate further returns over more periods
• D. Discounting, because a future amount is converted into today’s equivalent value

Best answer: C

What this tests: Principles of Investment Risk and Return

Explanation: The situation illustrates the time value of money through compounding. When money is invested earlier and returns are reinvested, each period’s return is added to the capital base for later periods. Over time, this creates returns on returns, so the holding period can have a large effect on the final investment value even when the fund, charges and expected annual return are unchanged. Discounting is the reverse process, used to express a future sum in present value terms. Diversification and pound-cost averaging are useful investment concepts, but they do not explain why the same lump sum invested earlier is expected to grow more by the same future date.

• Diversification may reduce unsystematic risk, but it does not completely remove market risk or explain growth from reinvested returns.
• Pound-cost averaging applies to phased investment, not a single lump sum invested now versus later.
• Discounting works backwards from a future value to a present value, rather than explaining the growth of money invested over time.

The earlier investment benefits from returns on both the original capital and reinvested returns for a longer period.

Question 5

Topic: Principles of Investment Risk and Return

A UK-based client needs portfolio withdrawals in sterling. Her portfolio includes:

• 40% short-dated UK gilt fund
• 25% UK equity income fund
• 25% unhedged global equity fund, mainly invested in US and Japanese shares
• 10% cash

During the quarter, the overseas shares were broadly unchanged in local currency, but sterling strengthened sharply. The global fund’s sterling unit price fell. Which risk driver is the primary source of this result?

• A. Liquidity risk from holding an open-ended global equity fund
• B. Inflation risk from the client’s future sterling spending need
• C. Stock-specific risk from inadequate diversification within UK equities
• D. Currency exposure from unhedged overseas holdings within the sterling-priced fund

Best answer: D

What this tests: Principles of Investment Risk and Return

Explanation: Currency risk can arise indirectly through the underlying assets in a fund. A UK investor may buy and sell units priced in sterling, but if the fund holds US and Japanese shares and does not hedge the currency exposure, changes in exchange rates affect the sterling value of those assets. Here, the overseas shares did not fall materially in their local markets; the loss arose because sterling strengthened, reducing the sterling value of foreign-currency assets. The client’s sterling withdrawal need makes this currency mismatch relevant to planning.

• Liquidity risk would be more relevant if the client could not sell units when needed or the fund suspended dealing.
• Inflation risk concerns loss of purchasing power over time, not a quarterly fall caused by exchange-rate movement.
• Stock-specific risk concerns poor diversification among individual shares, which is not the decisive fact here.

The fund is priced in sterling, but its unhedged overseas assets still expose the client to exchange-rate movements.

Question 6

Topic: Principles of Investment Risk and Return

A trainee adviser is reviewing a diversified equity fund and asks whether the Arbitrage Pricing Theory (APT) estimate must match a CAPM estimate because both use sensitivities described as betas. The APT inputs are:

The manager’s forecast return for the fund is 6.1%. Using these inputs, which statement is most accurate?

• A. The APT required return is 7.2%; the forecast is below it, because the inflation factor premium should be added despite the negative sensitivity.
• B. The APT required return is 9.0%; the forecast is below it, because APT adds all factor premiums directly to the risk-free rate.
• C. The APT required return is 5.2%; the forecast is above it, and APT need not match CAPM because it can use more than the market factor.
• D. The APT required return cannot be calculated unless the expected market return and market beta are known, because APT is CAPM with a different name.

Best answer: C

What this tests: Principles of Investment Risk and Return

Explanation: APT estimates the return required for exposure to several systematic risk factors. The calculation is the risk-free rate plus each factor sensitivity multiplied by that factor’s risk premium. Here, the growth exposure adds 3.2% and the negative inflation exposure subtracts 1.0%, so the total factor premium is 2.2%. Adding the 3.0% risk-free rate gives 5.2%. The forecast return of 6.1% is therefore above the APT estimate. APT is related to CAPM because both link expected return to systematic risk, but CAPM uses a single market factor, while APT can use multiple factors. APT’s practical limitation is that the relevant factors, premia and sensitivities must be selected and estimated.

• Adding the inflation premium as a positive amount reverses the effect of the fund’s negative inflation sensitivity.
• Adding factor premiums directly ignores the size and direction of the fund’s exposures.
• Requiring market beta and expected market return confuses APT with CAPM inputs.

The factor contribution is \(0.80 \times 4.0\% + (-0.50 \times 2.0\%) = 2.2\%\), giving an APT required return of 5.2%.

Question 7

Topic: Principles of Investment Risk and Return

A client will invest £4,000 at the end of each year for five years. Two suitable products have identical tax treatment, charges and liquidity. Product A is projected to grow at 3% a year compounded annually, while Product B is projected to grow at 5% a year compounded annually. Assuming the projections are achieved, which product and projected accumulated value best match the aim of maximising the value at the end of year 5?

• A. Product A, with a projected value of £20,000
• B. Product B, with a projected value of about £22,103
• C. Product B, with a projected value of about £25,526
• D. Product A, with a projected value of about £21,237

Best answer: B

What this tests: Principles of Investment Risk and Return

Explanation: For regular payments made at the end of each year, the future value is calculated as an ordinary annuity: each payment compounds only from the date it is invested to the end of the accumulation period. Product A gives approximately £4,000 × \([(1.03^5 - 1) / 0.03]\) = £21,237. Product B gives approximately £4,000 × \([(1.05^5 - 1) / 0.05]\) = £22,103. Since all other features are stated to be identical, the higher annual compound return is the decisive factor. Product B therefore produces the higher projected accumulated value at the end of year 5.

• Choosing Product A uses a lower projected accumulation, so it does not meet the aim of maximising the year 5 value.
• The £25,526 figure treats the full £20,000 as if it were invested for all five years, rather than recognising staged end-year payments.
• The £20,000 figure ignores compound growth entirely and is only the total amount contributed.

End-year regular payments at 5% compound to about £22,103, which is higher than Product A’s projected value.

Question 8

Topic: Principles of Investment Risk and Return

A client is reviewing the UK equity fund held in his stocks and shares ISA. He has a 10-year horizon, wants exposure close to the FTSE All-Share with low ongoing charges, and is considering an active fund that claims it can add value by using price charts, published trading updates, and private industry contacts. Which statement best describes the Efficient Markets Hypothesis point the adviser should make?

• A. Semi-strong efficiency means the client should avoid equity exposure because efficient markets remove the possibility of earning an equity risk premium.
• B. Weak-form efficiency says public announcements are already in the price, while semi-strong efficiency only says chart analysis should not work consistently.
• C. Strong-form efficiency means an active fund should be expected to outperform after charges if it has better private contacts than the market average.
• D. Weak-form efficiency questions the value of price charts, semi-strong efficiency questions the value of published trading updates, and strong-form efficiency would also question gains from private information.

Best answer: D

What this tests: Principles of Investment Risk and Return

Explanation: The Efficient Markets Hypothesis is about how quickly and fully information is reflected in security prices. Weak-form efficiency states that past price and volume data are already reflected, so chart-based trading should not produce persistent abnormal returns. Semi-strong efficiency extends this to all publicly available information, such as published trading updates and annual reports. Strong-form efficiency goes further and assumes even private information is reflected in prices. EMH does not say prices are always correct, that risk disappears, or that equities cannot offer a risk premium. For a client seeking broad FTSE All-Share exposure with low charges, EMH would generally support caution about paying higher active charges for strategies based only on information the market is expected to have absorbed.

• Reversing weak-form and semi-strong efficiency confuses past-price information with all public information.
• Efficient markets do not remove equity risk or the possibility of long-term risk premia.
• Private contacts would only be assumed unhelpful under strong-form efficiency, not a reason to expect reliable outperformance after charges.

The three EMH forms progressively assume prices reflect past price data, all public information, and then all public and private information.

Question 9

Topic: Principles of Investment Risk and Return

At an annual portfolio review, a client with no change in objectives, time horizon, or capacity for loss asks to sell a diversified bond fund and put the proceeds into a specialist technology fund because it has risen strongly over the past year. The client also refuses to sell a concentrated legacy shareholding that has fallen sharply, saying, “I do not want to lock in the loss until it gets back to what I paid.” What is the best next step for the adviser?

• A. Implement the technology fund switch because the client has given a clear instruction based on recent price momentum.
• B. Ask the technology fund provider to confirm whether the switch is suitable for the client.
• C. Pause the transaction, revisit the agreed risk profile and objectives, and discuss how loss aversion and performance chasing may affect the proposed changes.
• D. Sell the legacy shareholding immediately because refusing to crystallise a loss is always unsuitable.

Best answer: C

What this tests: Principles of Investment Risk and Return

Explanation: Behavioural-finance issues should be handled as part of the advice and review process, not treated as automatic trade signals. The client is showing possible performance chasing by extrapolating a recent price trend in the technology fund, and possible loss aversion by holding a concentrated losing share merely to avoid crystallising a loss. The adviser’s next step is to pause, revisit the client’s agreed objectives, risk tolerance, capacity for loss, diversification needs, and time horizon, and then explain how these biases could lead to unsuitable decisions. Only after that should any recommendation be made or transaction arranged.

• Acting only on recent price momentum skips suitability and may reinforce performance chasing.
• Selling the losing shareholding automatically overcorrects for loss aversion; the holding should be assessed against the client’s circumstances and portfolio.
• Suitability responsibility rests with the adviser, not the product provider.

The adviser should address the behavioural biases within the suitability process before recommending or arranging a portfolio change.

Question 10

Topic: Principles of Investment Risk and Return

A client refuses to sell a poorly performing share because accepting the loss would feel much worse than the satisfaction from making a similar gain elsewhere. Which behavioural-finance concept does this best illustrate?

• A. Anchoring
• B. Loss aversion
• C. Momentum investing
• D. Confirmation bias

Best answer: B

What this tests: Principles of Investment Risk and Return

Explanation: Behavioural finance considers how emotions and mental shortcuts can affect investment decisions. Loss aversion is the tendency for investors to dislike losses more intensely than they value equivalent gains. In practice, it can make clients reluctant to sell loss-making investments, even when selling would be rational for portfolio or tax reasons. The key feature is the unequal psychological impact of losses and gains, not the price movement itself or the investor’s information gathering process.

• Momentum investing focuses on recent price trends continuing, not the emotional weight of crystallising losses.
• Anchoring is over-reliance on an initial reference point, such as a purchase price or earlier valuation.
• Confirmation bias is favouring information that supports an existing view and discounting contrary evidence.

Loss aversion describes investors feeling the pain of losses more strongly than the pleasure of equivalent gains.

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