CISI Risk: Investment Risk

Topic snapshot

Sample questions

These questions are original Securities Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.

Question 1

Topic: Investment Risk

An investment committee reviews two funds for the same mandate. Fund A returned 8% over 6 months. Fund B returned 15% over 18 months. To compare performance fairly, which approach is best?

• A. Annualise both returns before comparing them.
• B. Scale only the 6-month return to 12 months.
• C. Compare the absolute pound gains instead.
• D. Choose the higher holding-period return.

Best answer: A

What this tests: Investment Risk

Explanation: Holding-period return shows the total return over the actual period invested. Because the two funds were measured over different lengths of time, the sound comparison is to annualise both returns to a common one-year basis.

Holding-period return measures the total gain over the period actually observed, so 8% over 6 months and 15% over 18 months are not directly comparable. Annualised performance converts each holding-period return into an equivalent yearly compounded rate, which is the proper like-for-like basis for comparing managers over different periods. In this case, the fund with the larger raw return over 18 months may still have the lower annual rate, because it took longer to earn that return. Comparing only the raw percentages confuses total return with rate of return, while comparing pound gains depends on how much money was invested. The key distinction is total return over a period versus return stated per year.

• Higher raw return: A larger holding-period return does not automatically mean better performance when the measurement periods differ.
• Scaling one return only: Adjusting only the shorter-period figure is inconsistent, and simple scaling is not the standard way to compare returns.
• Pound gains: Absolute profit reflects starting capital as well as performance, so it is not a clean comparison of investment returns.

Annualising both puts each holding-period return onto the same one-year basis, making the comparison valid.

Question 2

Topic: Investment Risk

An asset manager must report any single equity position above 30% of a portfolio’s current market value at the close of each day.

Using the correct basis for today’s risk report, which statement is correct?

• A. No holding breaches because none exceeds £3.0m in value.
• B. Aurelia plc is 24.7% of portfolio value and remains within the limit.
• C. Aurelia plc is 32.9% of current portfolio value and breaches the limit.
• D. Benton plc is 32.1% of portfolio value and breaches the limit.

Best answer: C

What this tests: Investment Risk

Explanation: The concentration test is based on current market value, not original cost. The current portfolio totals £8.5m, so Aurelia plc at £2.8m represents 32.9%, which is above the 30% reporting threshold. Accurate daily valuation therefore identifies a limit breach that should be escalated.

This tests concentration monitoring using the right valuation basis. Risk reports should reflect current exposure, because market movements can change the size of a holding even if no trades take place. Here, the current portfolio value is £8.5m and Aurelia plc is worth £2.8m, so its weight is 32.9%, which breaches the 30% limit.

• Current portfolio value = 2.8 + 2.4 + 1.9 + 1.4 = £8.5m
• Aurelia weight = 2.8 / 8.5 = 32.9%

Timely and accurate monitoring improves risk management because it allows the firm to report the breach promptly and consider actions such as rebalancing or tighter oversight. Historic cost is useful for performance analysis, but it does not show today’s concentration risk.

• Historic-cost trap: The statement showing Aurelia at 24.7% uses original cost, which understates current exposure and is not the basis for the daily limit test.
• Wrong holding: The statement showing Benton above 30% comes from reading the wrong figures; Benton is £2.4m of £8.5m, or 28.2%.
• Absolute-value trap: Comparing holdings with a £3.0m amount misses that the limit is relative to total portfolio value, not an absolute size.

The report must use current market values, and Aurelia is £2.8m out of a £8.5m portfolio, so its weight is 32.9%.

Question 3

Topic: Investment Risk

Which statement best describes the difference between nominal return and real return on an investment?

• A. Nominal return is after tax; real return is before tax.
• B. Nominal return measures income only; real return measures capital growth only.
• C. Nominal return is adjusted for inflation; real return is stated return.
• D. Nominal return is stated return; real return is adjusted for inflation.

Best answer: D

What this tests: Investment Risk

Explanation: Real return shows the change in purchasing power because it adjusts the stated, or nominal, return for inflation. Nominal return can appear positive even when the investor is worse off in real terms if prices rise quickly.

The core concept is purchasing power. Nominal return is the percentage return reported on an investment without allowing for inflation. Real return adjusts that nominal figure for inflation, so it shows whether the investor can actually buy more or less after general prices have changed. This is why inflation can reduce the investor’s true economic outcome even when the nominal return looks satisfactory. Tax, fees, and the split between income and capital growth are separate issues and do not define the difference between nominal and real return. The key distinction is simply whether inflation has been taken into account.

• Reversed definition: Inflation adjustment belongs to real return, not nominal return.
• Tax confusion: After-tax or before-tax treatment affects net return, but it is not the nominal-versus-real distinction.
• Source of return: Income and capital growth can both form part of either measure; they do not separate nominal from real return.

Real return is the nominal return adjusted for inflation, so it reflects the investor’s purchasing power.

Question 4

Topic: Investment Risk

A firm reviews asset-class returns across changing market conditions:

• Recession: government bonds +7%, equities -14%
• Recovery: equities +16%, bonds +2%
• Rising-rate year: cash +5%, bonds -6%, equities +4%

For a medium-risk portfolio, which action best applies a sound investment-risk principle?

• A. Base allocation mainly on long-run equity returns and ignore market conditions.
• B. Maintain a diversified mix of equities, bonds and cash, rebalanced to risk appetite.
• C. Remove bonds because one negative year shows they no longer diversify risk.
• D. Move fully into cash because it was strongest in the latest year.

Best answer: B

What this tests: Investment Risk

Explanation: Returns rotated across the conditions: bonds led in recession, equities in recovery, and cash in the rising-rate year. That pattern supports diversification and periodic rebalancing to a mix consistent with the portfolio’s risk appetite.

This tests the diversification principle in investment risk. The return pattern shows that no single asset class performs best in all market environments: bonds can support returns in recession, equities may lead in recovery, and cash can become more attractive when rates rise. Because asset-class returns vary over time and by market conditions, a medium-risk portfolio is usually better managed through a diversified strategic allocation and periodic rebalancing than by chasing the latest winner.

A sound approach is to:

• set the mix to the agreed risk appetite
• diversify across assets with different return drivers
• rebalance as market moves change portfolio weights

The key takeaway is that one weak or strong period does not remove an asset class’s role in a balanced portfolio.

• Moving fully into the latest winner is performance chasing and increases timing risk rather than controlling investment risk.
• Removing bonds after one weak period ignores their different behaviour in recessionary conditions, where they were the strongest asset shown.
• Using long-run equity returns alone misses the fact that portfolio outcomes depend on market regime as well as long-term averages.

Different asset classes lead in different conditions, so diversification and rebalancing best manage return variability within a medium-risk mandate.

Question 5

Topic: Investment Risk

Which statement best explains why returns over different time horizons are often annualised before comparison?

• A. They show the exact return that will be earned over a full year.
• B. They are adjusted to remove the effect of market volatility.
• C. They are put on a common yearly basis and interpreted using compounding.
• D. They are converted automatically from nominal to real returns.

Best answer: C

What this tests: Investment Risk

Explanation: Time horizon changes the meaning of a percentage return because the same number earned over different periods represents different growth rates. Annualising places returns on a common yearly basis, typically with compounding, so investments with different holding periods can be compared more meaningfully.

The core concept is that a holding-period return depends on the length of time over which it was earned. A 5% return over one month and a 5% return over one year are not equivalent, because the shorter-period return implies a much higher rate of growth if sustained. Annualising converts returns to a common per-year basis, usually using compounding, so they can be compared more consistently across investments or funds with different measurement periods.

Annualising does not change the underlying risk, remove volatility, or account for inflation by itself. It is also a standardisation tool rather than a forecast of what the next year will deliver.

The key point is that time horizon affects interpretation, so returns should be compared on a like-for-like annual basis.

• Volatility confusion: Annualising does not remove market volatility; risk still needs separate measures such as standard deviation or VaR.
• Inflation confusion: A real return requires an inflation adjustment, whereas annualising only changes the time basis.
• Forecast confusion: An annualised figure is a standardised yearly rate, not a guarantee that the same performance will continue for 12 months.

Annualising standardises returns from different holding periods onto the same time basis, making comparison more meaningful.

Question 6

Topic: Investment Risk

An investor made an initial fund purchase, added more capital six months later, and then made a partial withdrawal shortly before year-end. They want the return measure that best reflects their own outcome, including the size and timing of these cash flows. Which return concept best matches this need?

• A. Time-weighted return
• B. Money-weighted return
• C. Real return
• D. Annualised return

Best answer: B

What this tests: Investment Risk

Explanation: Money-weighted return is the best fit when external cash flows matter to the investor’s actual result. It reflects when money was added or withdrawn, so it matches a personal investment experience rather than isolating manager performance.

The core concept is that different return measures answer different questions. When an investor makes contributions or withdrawals during the period, and wants a measure of their own realised experience, the appropriate concept is money-weighted return. This measure gives weight to the timing and amount of cash flows, so a large addition before a gain or loss will affect the result.

Time-weighted return is more suitable for assessing the underlying portfolio manager because it removes the distorting effect of client-driven cash flows. Real return adjusts for inflation, and annualised return converts a return into a yearly rate, but neither one is primarily about the effect of cash-flow timing. The key takeaway is that investor-experience questions with changing cash flows point to money-weighted return.

• Manager assessment: Time-weighted return is mainly used to compare investment performance without the effect of investor cash-flow timing.
• Inflation focus: Real return shows purchasing-power change after inflation, not the effect of contributions and withdrawals.
• Period conversion: Annualised return standardises returns across time periods, but it does not by itself solve the cash-flow timing issue.

It captures the investor’s personal experience by incorporating both the amount and timing of contributions and withdrawals.

Question 7

Topic: Investment Risk

A private bank’s risk team reviews a sales pack for a discretionary portfolio. It highlights a one-year return of 8% but omits any net-of-charge or real-return figure. The 8% is before a 1% annual charge, which can be deducted directly from the return for this question. The client then pays 20% tax on the gain after charges, and CPI inflation over the year was 3%. Which interpretation is most accurate?

• A. The client’s real return is about 4%, because tax does not change return measurement.
• B. The client’s most relevant return is 5.6%, because inflation does not alter performance interpretation.
• C. The client’s actual outcome is still 8%, because charges and tax sit outside return analysis.
• D. The client’s real post-tax return is about 2.5%, so the 8% figure overstates purchasing-power growth.

Best answer: D

What this tests: Investment Risk

Explanation: The 8% figure is only a nominal, pre-charge return. After deducting the 1% charge, applying 20% tax to the remaining gain, and allowing for 3% inflation, the client’s real return is only about 2.5%, so the headline number materially overstates the outcome.

The key concept is that headline investment returns can differ materially from the investor’s true economic gain. Here, the reported 8% is before charges, tax and inflation, so it is not the best measure of the client’s experience.

• Start with the 8.0% headline return.
• Deduct the 1.0% charge: 7.0%.
• Apply 20% tax to that 7.0% gain: 7.0% × 0.80 = 5.6% post-tax nominal return.
• Adjust for 3.0% inflation: real return ≈ (1.056 / 1.03) - 1 = 2.5%.

So the client made a small real gain, not an 8% improvement in purchasing power. The closest distractors each ignore one of the required adjustments.

• Ignoring tax gives roughly 4%, but that still overstates the client’s net result.
• Using 5.6% captures the post-tax nominal return, not the inflation-adjusted outcome.
• Keeping 8% assumes charges and tax are irrelevant to client return interpretation, which is incorrect.

It correctly adjusts the headline return for charges, then tax, then inflation, leaving only a modest real gain.

Question 8

Topic: Investment Risk

Tracking error is primarily a measure of a portfolio’s:

• A. overall volatility of its absolute returns
• B. average return shortfall against its benchmark
• C. variability of returns relative to its benchmark
• D. sensitivity to movements in the wider market

Best answer: C

What this tests: Investment Risk

Explanation: Tracking error measures benchmark-relative risk, not absolute risk. It captures the dispersion of the portfolio’s active returns versus the benchmark, so a higher tracking error means the portfolio is deviating more from benchmark performance over time.

The core concept is that tracking error measures how much a portfolio’s returns vary relative to its benchmark. In practice, it is the standard deviation of active returns, where active return is the portfolio return minus the benchmark return. This means it indicates the degree of benchmark-relative risk being taken.

A low tracking error suggests the portfolio is closely following the benchmark. A high tracking error suggests the manager is taking larger active positions, so returns may differ more materially from the benchmark, whether positively or negatively.

The closest confusion is absolute volatility: a portfolio can have low absolute volatility but still have high tracking error if it differs consistently from the benchmark’s holdings or exposures.

• Average shortfall: this describes underperformance level, not the variability of deviations over time.
• Absolute volatility: this is total portfolio risk in isolation, not risk measured against a benchmark.
• Market sensitivity: this is closer to beta, which measures exposure to broad market movements rather than benchmark-tracking dispersion.

Tracking error is the standard deviation of active returns, showing how closely or loosely a portfolio tracks its benchmark.

Question 9

Topic: Investment Risk

A discretionary manager runs a £80 million balanced fund. After strong gains, 42% of its equity allocation is concentrated in four UK energy shares. The client mandate permits only long cash securities and collective funds, and the CIO wants overall equity exposure kept broadly unchanged. Which action would best reduce the portfolio’s risk?

• A. Short an energy-sector ETF against the current holdings
• B. Sell part of the energy positions and reinvest across other sectors and regions
• C. Buy FTSE 100 put options over the equity portfolio
• D. Buy credit default protection on the largest energy issuer

Best answer: B

What this tests: Investment Risk

Explanation: The main issue is concentration in one sector and a small number of shares, which creates non-systematic investment risk. Selling down that concentration and reinvesting more broadly reduces portfolio risk while keeping the fund’s overall equity exposure broadly intact.

This is primarily a concentration-risk problem, not a need to remove general market exposure. With 42% of the equity book in just four energy shares, the fund is highly exposed to sector-specific and company-specific events such as regulation, commodity-price moves, or earnings shocks. The most effective mitigation is diversification: reduce the oversized energy holdings and reallocate across less-correlated sectors and regions.

This approach fits all the stated facts:

• it addresses non-systematic risk directly
• it keeps the fund invested in equities overall
• it stays within a mandate limited to long cash securities and collective funds

A broad market hedge is the closest alternative, but it mainly targets systematic risk rather than the concentrated stock and sector exposure described.

• Index hedge: FTSE 100 put options are aimed at broad market falls, but the key problem here is concentrated sector and issuer exposure.
• Short selling: Shorting an energy ETF could offset the sector, but it breaches the long-only mandate.
• Risk transfer: Credit default protection targets default risk in one issuer, not the wider equity concentration across the energy holdings.

Diversifying away from a concentrated sector holding reduces non-systematic risk while keeping the fund broadly invested and within the mandate.

Question 10

Topic: Investment Risk

A pension fund permits its external manager to hold no more than 10% in any one issuer and to buy only investment-grade bonds. The portfolio later loses money on an authorised duration position, and a review also finds 14% invested in one issuer. Which control is designed to identify the investment-mandate issue rather than the market-view issue?

• A. Performance attribution analysis
• B. Interest-rate stress testing
• C. Pre- and post-trade mandate compliance monitoring
• D. Value at Risk reporting

Best answer: C

What this tests: Investment Risk

Explanation: The 14% issuer position is a mandate breach because it exceeds an agreed investment restriction. The loss on the authorised duration position reflects market view within mandate, so the matching control is mandate compliance monitoring.

This question tests the difference between a mandate issue and a market-view issue in investment risk. A mandate issue arises when the manager goes outside agreed client constraints, such as issuer, rating, asset-class, or concentration limits. Here, holding 14% in one issuer breaches the 10% cap, so the relevant control is pre- and post-trade mandate compliance monitoring. By contrast, losing money on an authorised duration position is a market-view issue: the manager stayed within the rules but the investment judgement did not work.

VaR and stress testing measure potential loss from market movements, while performance attribution helps explain return outcomes. Those tools may illuminate the poor market call, but they do not primarily police mandate restrictions.

• Market-risk measure: Value at Risk estimates potential loss from market moves, not whether a holding is permitted under the mandate.
• Return diagnosis: Performance attribution can explain why the authorised duration position lost money, but it is not the main control for detecting breaches of client limits.
• Scenario analysis: Interest-rate stress testing shows sensitivity to rate shocks, again focusing on market exposure rather than issuer-limit compliance.

It checks proposed and actual holdings against client restrictions such as issuer limits, regardless of whether an authorised position made or lost money.

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Related focused pages

• Free CISI Risk Full-Length Practice Exam
• CISI Risk: Principles of Risk Management
• CISI Risk: International Risk Regulation
• CISI Risk: Operational Risk
• CISI Risk: Credit Risk
• CISI Risk: Market Risk
• CISI Risk: Liquidity Risk
• CISI Risk: Model Risk
• CISI Risk: Risk Oversight and Corporate Governance
• CISI Risk: Enterprise Risk Management (ERM)

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