Diversification of a portfolio among asset classes:
A
increases the rate of return achieved over the investment time horizon
B
reduces the rate of
... [Show More] return achieved over the investment time horizon
C
reduces the variability of the rate of return over the investment time horizon
D
increases the variability of the rate of return over the investment time horizon
C. Diversification reduces the variability of investment returns over the investment time horizon. In a diversified portfolio, some investments will be under-performing and some will be over-performing, tending to average out the rate of return. Thus, variability of the rate of return is reduced.
The use of index funds as investment vehicles for asset classes increases:
A
diversification
B
expected rate of return
C
standard deviation of return
D
market risk
A. Index funds are broadly diversified, since they hold all of the securities in the designated index. This reduces market risk or the standard deviation of returns. The impact of diversification on rate of return should be one of lowering the rate of return compared to the market average, along with lowering the risk associated with that rate of return.
Which of the following would be least important in determining the level of diversification in a corporate bond portfolio?
A
Bond ratings
B
Industries represented in portfolio
C
Domicile of issuers
D
Maturities of the bonds in the portfolio
C. The "domicile" of an issuer is the state where the issuer legally resides. It has no bearing on the quality of the issuer's securities. Bond rating, type of industry, and maturity would all be considered when examining the diversification of a bond portfolio.
A customer holds a large portfolio of corporate bonds. The customer is worried about capital risk. Which diversification strategy would be least effective to minimize capital risk for this customer?
A
Diversification among differing issuers in differing states
B
Diversification among differing denominations
C
Diversification among differing industries
D
Diversification among differing maturities
B. Effective methods of diversifying away the unsystematic risk of a portfolio would be to diversify among different issuers, different states, and different industries. Thus, if one issuer, industry or economic region has problems, this would only affect a small portion of the portfolio. Diversification among differing maturities also provides a measure of risk management. If market interest rates rise, short term maturities (under 1 year) will decline in price by a minimal amount compared with longer maturities. Thus, a mix of maturities helps to minimize capital risk. Bond denominations have no bearing on diversification.
Passive portfolio management is:
A
buying and holding the investments chosen by the Registered Representative
B
determining the securities to be bought or sold based on investment research performed by the Registered Representative
C
managing a portfolio to meet the performance of a benchmark portfolio
D
managing a portfolio to exceed the performance of a benchmark portfolio
C. Passive portfolio management is the management of a portfolio to meet the performance of a benchmark, such as a designated index. Active portfolio management attempts to beat the performance of the benchmark portfolio through better security selection and better investment timing.
Review
The portfolio management technique that uses a market index as a performance benchmark that the asset manager must exceed is called:
A
Passive asset management
B
Active asset management
C
Strategic asset management
D
Tactical asset management
B. Active asset management is the management of a portfolio to exceed a benchmark return (say the return of a comparable index fund). The manager's "active" return is any incremental return achieved over the benchmark return. In contrast, passive asset management is simply the management of a portfolio to match the benchmark return (the "passive return"). Active managers believe that underpriced securities can be found in the market and that performance of the benchmark can be exceeded. Passive managers believe that the market is efficient at pricing securities and that one cannot do any better than the "market" return as measured by a relevant index.
The setting of specific goals for an investment plan to be created for a customer is known as:
A
Strategic asset management
B
Tactical asset management
C
Dollar cost averaging
D
Portfolio rebalancing
A.
Strategic asset management is the setting of the investment "strategy" under an asset allocation scheme.
Tactical asset management is the permitted variation to the established strategy, to take advantage of market opportunities.
Dollar cost averaging is the periodic (say monthly) investment of a fixed dollar amount into a given security. By using dollar cost averaging, the average cost per share purchased can be lower than the arithmetical average cost of the security over the same time frame - as long as the security's price has been moving up and down (as the security's price drops, the fixed periodic dollar amount buys proportionately more shares than when the security's price rises).
Portfolio rebalancing is used in an asset allocation scheme when a chosen asset class outperforms the others, so that its percentage allocation increases beyond the strategic limit. The excess in that class is sold off and the proceeds reinvested in the other asset classes to rebalance the portfolio back to its strategically set percentages.
Tactical portfolio management is the selection of the:
A
securities in which to invest
B
asset classes in which to invest
C
target asset allocation for each asset class selected for investment
D
variation permitted in target asset allocation for each asset class selected for investment
D. Strategic asset allocation is the determination of the target percentage to be allocated to each asset class (e.g., 25% Treasuries; 25% Corp. Debt; 50% Equities). Tactical asset allocation is the permitted variation around each of the chosen percentages - for example, even though Equities are targeted at 50%, this might be allowed to be dropped to as low as 40%, or as high as 60%, depending on market conditions.
Which statements are TRUE about asset classes and investment time horizons?
I Equity investments are the better choice for short term time horizons
II Interest bearing investments are the better choice for short term time horizons
III Equity investments are the better choice for long term time horizons
IV Interest bearing investments are the better choice for long term time horizons
A
I and III
B
I and IV
C
II and III
D
II and IV
C. Equity investments typically produce a higher rate of return with higher volatility - thus a long time horizon is needed to achieve consistent results with equity investments. Interest bearing investments produce a lower rate of return with lower volatility - thus they are suitable for portfolios with short time horizons.
The time horizon to be used when constructing a portfolio to pay for college expenses for a person who is expected to start college in 10 years and finish college in 15 years is:
A
5 years
B
10 years
C
12.5 years
D
15 years
D. If a portfolio is being constructed to fund a person's college education, it must be able to provide income to pay for college until schooling is finished.
Review
Value investors:
A
seek to find investments that are undervalued by the market
B
determine the value of a security through fundamental analysis
C
invest in securities included in the Value Line Index
D
make their investment decision based upon the market performance of the security
A. Value investors believe that the market is not completely efficient at pricing securities and that undervalued securities can be found in the marketplace. Once the market realizes the true worth of these undervalued companies, their prices should rise at a greater rate than the general market.
The investment strategy that involves paying a lower price for a security based on the expectation that the market is mispricing the issue is:
A
growth investing
B
value investing
C
passive investing
D
active investing
B. Value investing is the selection of equity investments based on finding securities that are fundamentally undervalued in the marketplace. These tend to be solid companies that are currently "out of favor." Value investors look at such fundamental factors as the Price/Earnings ratio; and Price/Book Value ratio to find companies that are undervalued relative to their market sector.
An investment strategy where a higher price is paid for a stock based upon expected returns is:
A
growth investing
B
value investing
C
conservative investing
D
passive investing
A. A growth investor buys a stock based upon demonstrated growth in earnings or sales over time. The theory is that such companies can continue to grow rapidly, and therefore should command a higher market price.
If one asset class greatly underperforms another class in an asset allocation plan, the portfolio must be:
A
renegotiated
B
rebalanced
C
repositioned
D
realigned
B. When investment performance varies over time from one asset class to another, the target percentage allocations will shift from their optimal setting. To bring the portfolio back to these targets, it must be rebalanced - that is, a portion of the overperforming class(es) must be sold off and the proceeds reinvested in the underperforming class(es).
Which bond portfolio where all investment is made up front would be LEAST negatively affected by a sharp rise in interest rates?
A
Ladder
B
Bullet
C
Barbell
D
Balloon
A.
Bullets, Bond Ladders, and Barbells are portfolio constructions that are used to limit interest rate risk.
The idea behind a bond ladder is to spread bond maturities in a portfolio over fixed intervals, typically 10 maturities in intervals of 2 years each. A typical ladder might have 10 maturities ranging from 2 to 20 years, with an average maturity of around 10 years. Because of this broad diversification by maturity, a rise in interest rates will not impact the portfolio as negatively as compared to a bullet or barbell portfolio construction. If interest rates rise, the loss on the longer term bonds in the portfolio is offset by the fact that shorter term bonds are maturing soon and the proceeds can be reinvested at higher rates.
A barbell portfolio only has 2 maturities - a very short term and a very long term - say 2 years and 20 years, for an average life around 10 years (actually 11 years here, but we are simplifying things). The longer term bonds give a higher yield but have higher interest rate risk. This risk is offset by the fact that the 2 year bonds will mature soon and the proceeds can be reinvested at higher rates. The big risk here is that long rates rise sharply as compared to short rates (a steepening of the yield curve). In this scenario, the loss on the long term bonds will be much greater than the fact that the short term bond proceeds can be reinvested in 2 years at somewhat higher rates.
A bullet portfolio construction only has a single maturity, typically in an intermediate range of around 10 years. The way that interest rate risk is offset here is that all of the investment is not made at one time - rather, the investment is made in installments at fixed intervals. If market interest rates rise, new investment will be made at higher rates, offsetting any loss on the already purchased bonds. Also note that this cannot be a correct answer to the question because all investment is not made up front - rather, the investment is made in stages.
A balloon is a type of bond issue structure, where most of the bonds mature as a "balloon" at a long term maturity date. It is not a type of bond portfolio construction.
A registered representative has a client who is an exceptionally intelligent doctor of medicine. The doctor does most of his own investment research and makes many of his own investment decisions. The doctor is married, but his wife is not involved in the investment planning or decision-making process. When constructing a portfolio for this client, the registered representative should:
A
choose the investments in the portfolio based solely on the research conducted by the doctor
B
balance the portfolio in a manner that addresses the doctor's investment strategy and that customizes the strategy to meet the needs of the spouse
C
charge fees on the assets held in the portfolio that were chosen by the representative without using the doctor's research
D
disregard the doctor's research because the doctor is not properly licensed to act as a representative
B. When constructing a portfolio for a client, the representative can take into account a customer's special expertise in a given area when selecting specific investments. For example, a doctor might have a special insight into the sales prospects for a medical device manufacturer, and could tell the representative that he wants to invest in this company. It is the role of the representative to review this investment decision and, if appropriate, to make sure that it is not overweighted in the portfolio. Because the doctor is married, the representative should construct the portfolio to meet both the needs of the doctor and his wife.
An investor has a long-term investment time horizon, no liquidity needs and is very risk averse. Your main concern when making a recommendation to this client is:
A
preservation of capital
B
safety of principal
C
continuing income
D
adequate yield
B.
This client has no liquidity needs, so Choices C and D - continuing income and adequate yield, are not concerns. So it comes down to whether the main concern is preservation of capital or safety of principal.
Preservation of capital is a concern for client who has no buffer if investment values decline. Such a client cannot afford to lose any money and should only be recommended CDs and money market funds as an investment. Because this client has "no liquidity needs," he or she is not in this situation.
Safety of principal is the better answer as a "concern." This type of client doesn't want his or her principal put at risk - he or she is just averse to taking on risk, but can afford to do so. Such a client could be recommended CDs, money market funds, short term bonds and laddered bond portfolios.
A new client with no other investment assets has just come into an inheritance of $500,000 of ABCD stock, a blue chip company listed on the NYSE. As the adviser to this customer, your IMMEDIATE concern should be:
A
whether the company is a candidate for delisting
B
the possibility that the value of ABCD stock may decline sharply
C
the lack of diversification of the customer's investment
D
whether the customer paid any estate tax liability due
C. This is the client's sole investment. Because this is a blue chip company, it is not likely to be delisted. It is also not likely to suffer a sharp price decline, though this could occur. The immediate concern should be the customer's lack of diversification. If the customer were to sell a portion of the ABCD stock and reallocate it to other investments, the client will reduce overall risk.
An individual who is 25 years from retirement has $500,000 to invest today. He is risk tolerant and is looking to withdraw $80,000 per year once he retires. Which asset allocation is BEST for this client?
A
25% Stocks / 25% Bonds / 25% REITs / 25% Money Markets
B
50% Stocks / 40% Bonds/ 10% Cash
C
100% Bonds
D
100% Stocks
B.
We are not given the age of this customer, but since he or she is 25 years from retirement, we can guess that the customer is around 40-50 years old. Based on the rule of thumb that "100% minus the customer's age" should be allocated to stocks for growth, a stock allocation of 40-50% is about right. This makes Choice B the best offered. No asset class diversification (Choices C and D) is not the way to go (100% stocks is too risky and 100% bonds is too conservative). The asset allocation offered in Choice A is not weighted heavily enough in stocks and is too conservative to meet the customer's goal.
Also note, that while not relevant to the question, if the $500,000 invested earns 5% per year, after 25 years, the account will be worth about $1,700,000. If the customer is now age 65 or so, this would give retirement income for around 20 years at the rate of $80,000 per year.
What portfolio construction is most appropriate for a retired doctor who is age 75?
A
100% common stocks
B
75% common stock / 25% bonds
C
25% common stock / 75% bonds
D
100% bonds
C. As one gets older, portfolio composition should shift to "safer" assets that generate reliable income. The general rule is to take "100 minus the investor's age" to get the appropriate investment portion to be held in stocks. Since this investor is age 75, this gives 25% of the portfolio holding in stocks; with the remaining 75% of the holding in bonds. Note that a 100% bond holding is not appropriate because people are living much longer and they need the "extra return" that is provided by stocks that can grow in value, on top of the somewhat lower fixed return provided by bonds.
A constant ratio investment plan requires:
A
that the same percentage amount be invested periodically in new equities purchases
B
that the same percentage amount be kept invested in equities
C
the constant reinvestment of all dividends and interest received in the percentage as the securities held in the portfolio
D
that a constant percentage amount be invested in U.S. securities
B. Under a constant ratio plan, a portfolio manager sets a fixed percentage level (say 70% of total asset value) to be maintained in equity securities. If the value rises above 70%, the excess is sold, and invested in debt securities. Conversely, if the equity market value drops below 70% of the portfolio, bonds are liquidated and invested in equities to bring the equity balance to the constant 70%.
Institutional portfolio managers have been allocating an increasing percentage of their funds to common stock positions. This is an indication that their market sentiment is:
A
bullish
B
neutral
C
bearish
D
cautious
A. From a "market sentiment" standpoint, a portfolio manager will decrease the cash position and increase the portion of the portfolio invested in common stocks when he or she is bullish on the market. Conversely, if the manager is bearish on the market, he or she will increase the cash position; and decrease the portion of funds invested in securities. [Show Less]