Suzanne holds a portfolio spread across 60 shares in eight countries, four bond funds and a listed property fund, and she rebalances annually. She tells her planner she assumes this spread has dealt with her investment risk, and asks what she remains fully exposed to. Which risk is it?
- ABusiness risk, arising from the variability of operating profits at the individual companies whose shares she owns across the eight countries.
- BFinancial risk, arising from the amount of debt carried in the capital structures of the companies whose shares and bonds she owns.
- CDefault risk, arising from the possibility that a bond issuer inside one of her four bond funds fails to pay a coupon or repay principal on time.
- DPurchasing power risk, arising because inflation reduces the real value of returns across asset classes and holding more securities does not remove that exposure. Correct
Why A is wrong: Tempting because business risk is a genuine equity risk and she owns a lot of equities. It is wrong because business risk is company specific, so holding 60 issuers across eight markets is precisely what reduces it.
Why B is wrong: Tempting because leverage magnifies losses and does raise the risk of any single holding. It is wrong because gearing differs from issuer to issuer, which makes financial risk unsystematic and reducible by holding many issuers.
Why C is wrong: Tempting because default is a real bond risk and she holds four bond funds. It is wrong because default is issuer specific, and pooled funds holding many issuers are the standard way of diversifying it away.
Why D is correct: Correct. Purchasing power risk is systematic. Inflation reduces the real value of nominal returns whatever the mix of issuers, so spreading capital across more securities and markets leaves the exposure intact.