3. Investment Planning - All Exam Tips and Practitioner's Advice Flashcards

Question

# PRACTITIONER ADVICE PRACTITIONER ADVICE o A time-weighted return is a geometric return which often requires using the N key for the root calculation. In the example above, the two returns are semi-annual, which, when multiplied, produce the annual return. o If the same example had used annual figures, a square root calculation would be necessary, as denoted in the Geometric Mean Return formula.

Answer 1

An alternative method for calculating the real interest rate is to **subtract the inflation rate from the nominal return (as a whole number), and then dividing that amount by 1 plus the inflation rate**. Using the same example above, 11 - 4 = 7. Then 7/1.04 = 6.73. This is the real (or inflation adjusted) return, and is already expressed in the correct format for your calculator. The other method requires you to convert the decimal expression to a whole number.

Answer 2

**PRACTITIONER ADVICE:** **Time horizon helps to determine the amount of risk an investor should take. For example, if an investor has three years left until reaching their financial goal, they should consider moving their investments to a more conservative holding. Let’s say in the three years that remain, the investor could earn a 6%/yr return in a bond investment versus an 11%/yr return in a stock investment. Most people at first glance would want the 11% from the stock. However, the stock investment is much more volatile than the bond investment.** **Let's assume the standard deviation of the stock market is 15%. You know from your readings of module 196 (Investment Risks) the probability of the expected return (in this case 11%) plus or minus two standard deviations is approximately 95%. This means that in any particular year, even though the expected return is 11%, there is a 95% probability that the actual return for the upcoming year will range anywhere from -19% to 41%. The Investment Risk module also discussed the influence of time on the standard deviation. Over a three year holding period, the effective standard deviation of the investment would be 8.66% [ 15% / square root of 3 ]. Over the time horizon of three years, there is a 95% probability that the return would be in the range of -6.32% to 28.32%. The correct financial planning perspective is to avoid equity investments with such a short time horizon.**

Answer 3

To ensure that you have a solid understanding of capitalization of income (stock), the following topics will be covered in this lesson: * Net present value * Internal rate of return * Application to common stocks Upon completion of this lesson, you should be able to: * Calculate net present value, * Compute internal rate of return, and * Determine the value of common stocks. **PRACTITIONER ADVICE Please note that different financial authors may use different terms for the same concept. While the author from the original textbook uses stock valuation terms of Net Present Value and Internal Rate of Return for the dividend discount models, the current textbook's author uses contemporary terms of intrinsic value and expected return.**

Answer 4

A more general DDM for valuing common stocks is the multiple-growth model. With this model, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g). Valuing a share of common stock with the multiple-growth model requires that the present value of the forecast stream of dividends be determined. This process can be facilitated by dividing the expected dividend stream into two parts: * finding the present value of each part, and * adding these two present values together. The first part consists of finding the present value of all the forecast dividends that will be paid up to and including time T, and denoting this present value by VT. The second part consists of finding the present value of all the forecast dividends that will be paid after time T and involves the application of the constant-growth model. The value of the stock = V = VT- + VT+ V=∑Tt=1Dt(1+k)t+Dt+1(k−g)(1+k)T The two-stage model assumes that a constant growth rate (g1) exists only until some time (T), when a different growth rate (g2) is assumed to begin and continue thereafter. **Practitioner Advice: Economic conditions and company forecasts are constantly changing. As a result, valuation methods that offer flexibility in company growth projections are especially valuable. The most useful of the dividend discount models, therefore, is the two-stage model because it is the only one that allows for a fast growth phase where g > k, followed by a "normal" phase where k > g.** **Exam Tip: Here's the typical fact pattern for Multi-Stage Dividend Discount Model questions: A client owns a stock paying a certain dividend rate, which changes to another (constant) dividend rate in the future. A time frame and the client’s required rate of return will be provided. From there, you will be asked to calculate the valuation of the stock based on the dividend payments and, possibly, use a valuation result to determine whether a stock is overvalued or undervalued in the market. As the name of the calculation states, there are many steps to conduct as you work toward a solution. Know that breaking the problem into three, smaller problems, makes the calculation more manageable and easier to understand.**

Answer 5

**PRACTITIONER ADVICE: The problem with looking at a company's P/E is that you cannot be sure how they are forecasted. For example, published earnings figures are based on the previous four quarters, while other publications may use the current quarter and project it out for the next four quarters. If the company had an exceptionally good or exceptionally bad quarter, it is amplified by being used as the predictor of the next three quarters. A problem arises when aberrations from the norm are explained away as being warranted, when in fact they are the result of greedy investors.**

Answer 6

PRACTITIONER ADVICE: Most of the ratios will not need to be memorized because the name of the formula usually guides your calculation. * The word "**margin**" usually means **sales in the denominator** * The word "**turnover**" usually means **sales in the numerator**.

Answer 7

When investing in different securities, the percentage of change in an investor's wealth from the beginning to the end of the year can be calculated in terms of the rate of return as: HPR = ((P1 - P0 )+D)/P0, or Holding Period Return = ((End-of-Period Wealth - Beginning-of-Period Wealth) + Income)/Beginning-of-Period Wealth The above formula is used to calculate the one-period rate of return on a security, where beginning-of-period wealth is the purchase price of one unit of the security at t = 0. The end-of-period wealth is the market value of the unit at t = 1, along with the value of any cash (and cash equivalents) paid to the owner of the security between t = 0 and t = 1. One must also remember that in the calculation of the return on a security, it is assumed that a hypothetical investor purchased one unit of the security at the beginning of the period. **TEST TIP Since the formulas on the distributed formula sheet for the CFP Certification Exam are not labeled, it is as important to recognize a formula by its components. Most questions that offer a beginning wealth (or price) and an ending wealth (or price) will have something to do with the Holding Period Return equation. The equation could also be manipulated where the return is given and you must solve for the ending or beginning wealth (price).**

Answer 8

An alternative method for calculating the expected return on this portfolio is shown below. This procedure involves calculating the expected return on a portfolio as the weighted average of the expected returns on its component securities. The relative market values of the securities in the portfolio are used as weights. In symbols, the general rule for calculating the expected return on a portfolio consisting of N securities is: rp=∑Nj=1Xjr⎯⎯i=X1r⎯⎯1+X2r2+...+XNr⎯⎯N where: rp = the expected return of the portfolio XI = the proportion of the portfolio's initial value invested in security I rI = the expected return of security I N = the number of securities in the portfolio **TEST TIP The formula sheet for the CFP examination has the following formula for determining the expected return of a portfolio, also know as the Capital Market Line. This equation assumes the existence of both systematic and nonsystematic risks: Rp= Rf + SDP[(Rm -- Rf)/SDm]**

Answer 9

Closely related to covariance is the statistical measure known as correlation coefficient. In fact, when it comes to diversification, the correlation coefficient is the most important statistic. Correlation coefficients always lie between -1.0 and +1.0. A value of +1.0 represents perfect positive correlation. A value of -1.0 represents perfect negative correlation. In the real world, most financial assets have positive correlation coefficients ranging in value from 0.4 to 0.9. However, for purposes of diversification, combining assets with anything other than perfect positive (+1.0) correlation will have diversification benefits. The lower the coefficient (e.g., 0.4 vs. 0.7) the better, and negative is much better than positive. If you could ever find perfect negatively correlated assets (in theory anyway), you could have zero risk with just two assets. Your return would be with complete certainty. The difference between correlation coefficient and covariance is that covariance is more of a refined statistic, designed to take to specific asset risk into account. Correlation coefficients are raw figures, which simply measure the degree of variation between two assets returns from one period to the next. The correlation coefficient squared is known as the **coefficient of determination** in the statistical-world, but commonly known as R squared in the every-day world. The R squared is another extremely important statistic, in that it tells you the degree to which a fund or a portfolio is diversified. Technically, it tells you the degree to which a dependent variable's variation in returns (say a stock mutual fund), are explained by the variation of returns of an independent variable (say a benchmark such as the S&P). To now think of this statistic in a managerial context is the key. For example, If I have a fund with an R squared of 0.92, that tells me that 92% of the variation of the funds returns are due to systematic forces (nondiversifiable). More importantly, it tells me 8% of the variation of the funds returns are due to unsystematic or diversifiable risk. **TEST TIP** **Beta is not an appropriate measure of risk in situations when the portfolio being analyzed has a R squared below .70. This also has ramifications for the appropriateness of performance indices that use beta (Treynor and Jensen).**

Answer 10

* Initial and terminal wealth: Used to calculate the rate of return and help to decide the expected returns and standard deviations for portfolios. * Expected return and standard deviation: Expected returns can be determined based on the terminal versus initial value or a weighted sum of the securities' expected return. The risk (standard deviation) of a portfolio can be determined using the double summation method, which examines the securities' covariance and correlation. **PRACTITIONER ADVICE Computer programs are available to help determine portfolio return and risk data. It is more important to understand how they work and what they mean to an investor. A conversation about covariance may confuse a novice investor more than it helps. However, if your clients were directed to certain statistics such as R-squared on sales material or third party rating reports, it would be helpful for you to know what these statistics mean to a portfolio's expected risk and return.**

Answer 11

Dividend Reinvesting If you want to use common stock to accumulate wealth, you must reinvest rather than spend your dividends. Under a dividend reinvestment plan (DRIP), you are allowed to reinvest the dividend in the company’s stock automatically without paying any brokerage fees. Most large companies offer such plans, and many stockholders take advantage of them. However, DRIPs have several drawbacks, including: * When you sell your stock, you’ll have to figure your cost basis for your dividends that are reinvested (most brokerage firms do this automatically for clients). In addition, you will pay income tax on the reinvested amounts as if you actually received these dividends. * You can’t choose what to do with your own dividend. For example, if the company you’ve invested in is performing moderately well, and you just heard about another company whose stock price is rising faster. You are stuck reinvesting instead of trying something new. Example (Dividend Reinvestment Plans) An investor bought 150 shares of a local savings bank. He was receiving cash dividends, but then decided to take advantage of the dividend reinvestment program. The 150 shares split at one point, so he had 300 shares from his original purchase. However, due to dividend reinvestment, he has over 750 shares altogether. His father bought 100 shares at the same time that he did, but never took advantage of the dividend reinvestment and has only 200 shares now.

Answer 12

A market-timer structures a portfolio to have a relatively high beta when he expects the market to rise and a relatively low beta when a market drop is anticipated. In other words, a market timer will: * Hold a high-beta portfolio when Expected Market Return > Risk-free Return, and * Hold a low-beta portfolio when Expected Market Return < Risk-free Return. If the timer is accurate in his forecast of the expected return on the market, then his portfolio will outperform a benchmark portfolio that has a constant beta equal to the average beta of the timer's portfolio. However, forecasting the market return is the hard part. The actual result will be determined by the accuracy of his or her forecast regarding the relationship between the market's return versus a risk-free return. To "time the market," one must change either the average beta of the risky securities held in the portfolio or the relative amounts invested in the risk free assets and risky securities. For example, selling bonds or low-beta stocks and using the proceeds to purchase high-beta stocks could increase the beta of a portfolio. Alternatively, Treasury bills in the portfolio could be sold, with proceeds being invested in stocks or stock index futures. Because of the relative ease of buying and selling derivative instruments such as stock index futures, most investment organizations specializing in market timing prefer the latter approach. CASE-IN-POINT: * **Remember, having a high beta does not necessarily mean that the portfolio will behave like the market**. * **R-squared (coefficient of determination) should also be checked to determine how closely correlated the portfolio is to the market**. PRACTITIONER ADVICE: **Market timing is very hard to accomplish. People rarely get it perfect. Not only must you decide when to get out of the market before it starts to going down, but you also have to determine the precise moment to get back in to take advantage of an expansion. Often, bottom fishers will buy into the market after a significant adjustment, effectively stopping the downward momentum. However, they will also take profits shortly thereafter, which restarts the market's downward momentum. For market timers who have been waiting for signs of a switch in the business cycle stage, these short-term fluctuations can be very misleading.**

Answer 13

Within the investment industry, a distinction is often made between passive management - holding securities for relatively long periods with small and infrequent changes - and active management. * **Passive managers** generally act as if the security markets are relatively efficient. Put somewhat differently, their decisions are consistent with the acceptance of consensus estimates of risk and return. The portfolios they hold may be surrogates for the market portfolio, known as index funds, or they may be portfolios that are tailored to suit clients with preferences and circumstances that differ from those of the average investor. In either case, passive portfolio managers do not try to outperform their designated benchmarks. * **Active managers** believe that from time to time there are mispriced securities or groups of securities. They do not act as if they believe that security markets are efficient. Put somewhat differently, they use deviant predictions; that is, their forecasts of risks and expected returns differ from consensus opinions. For example, a passive manager might only have to choose the appropriate mixture of Treasury bills and an index fund that is a surrogate for the market portfolio. The optimal mixture is only changed when: * The client's preference changes, * The risk-free rate changes, or * The consensus forecast about the risk and return of the benchmark portfolio changes. The manager must continue to monitor the last two variables and keep in touch with the client concerning the first one. No additional activity is required. Passive Management Management Style * S&P Index Fund Passive * SPIDR (ETF) Passive * Growth & Income Fund Active * Small Co. Value Fund Active **Practitioner Advice: Typically, a blended approach is used in portfolio management when a portion of the assets is bought and left alone while another portion is actively managed. Also, a client may apply a passive buy and hold strategy, but then occasionally rebalance the asset allocation to actively manage the portfolio. Moreover, some securities are more suited for passive strategies than others. Large cap stocks have a more efficient market (according to the Efficient Market Hypothesis), so they are more suited for passive investment than smaller companies.**

Answer 14

One of the major divisions in the ranks of financial analysts is between those using fundamental analysis and those using technical analysis. Technical analysis is the study of the internal stock exchange information. The word technical implies a study of the market itself, the "push" and "pull" of supply and demand forces on the market. Technical analysts track market statistics such as price levels and the trade volume in the exchanges. The technician usually attempts to predict short-term price movements and thus makes recommendations concerning the timing of purchases and sales of either specific stocks, groups of stocks (such as industries), or stocks in general. The methodology of technical analysis rests upon the assumption that history tends to repeat itself in the stock exchange. Thus, technicians assert that the study of past patterns of variables such as prices and volumes will allow the investor to accurately identify times when certain specific stocks (or groups of stocks, or the market in general) are either overpriced or under priced. Most, but not all, technical analysts rely on charts of stock prices and trading volumes. Technical analysis uses the following methodologies to determine profitable stock selection and market timing opportunities: * Charting Strategies involve the examination of historical price patterns, moving average and trading breakout techniques. * Sentiment Indicators include contrarian statistics and one of the most accurate of all technical indicators, the Barron's Confidence Index. * Flow of Funds Indicators examine the amount of funds that are available to invest. * Market Structure Indicators involve looking at the desirability of the overall market and opportunistic entry points. PRACTITIONER ADVICE: **Technical analysts are not concerned with the fundamental prospects of a firm. In fact, what the company does, what they make, their relative market share, etc., is all unimportant information according to a technician. The company's recent price action relative to volume and volume reversals are the only things that matter. It is important to note that proponents of any form of the Efficient Market Hypothesis (EMH) do not recognize technical analysis as adding any value to security selection. Likewise, technicians do not believe the EMH to be valid.**

Answer 15

The following is an example of a moving average strategy: * Calculate the average closing price of a given stock over the last 200 trading days. * Take today's closing price and divide it by the 200-day average to form a short-to-long price ratio. * A ratio greater than 1 is a buy signal that indicates that the stock is to be bought tomorrow. A ratio of less than 1 is a sell signal that indicates that the stock is to be sold tomorrow. * Tomorrow after closing, repeat the above process. * At the end of a test period, calculate the average daily return during both the "buy" days and the "sell" days. **If the stock market is efficient, the average return during the buy days should be approximately the same as the average return during the sell days. That is, the difference in their returns should be approximately zero**. However, technical analysis may have merit if they were significantly different. Because this strategy classifies every day as either a buy day or a sell day, thereby allowing a given stock to be bought on consecutive days, it is referred to as a **variable-length moving average strategy**. A **fixed-length moving average strategy** can reduce the frequency of changing positions from buying to selling, or from selling to buying. Buy signals are now generated only when the ratio changes from <1 to >1, and sell signals are generated when the ratio changes from >1 to <1. When a buy signal is generated, the stock is bought the next day and held for ten days. Similarly, when a sell signal is generated, the stock is sold and not bought for ten days. In either case, when the ten days are over, the investor starts looking again for a buy or a sell signal. Whereas the variable-length strategy classified every day as either a buy or a sell day, there can be days that are not classified as either buy or sell with the fixed-length strategy. **Practitioner Advice: This type of technical analysis is sometimes referred to as point and figure charting. The idea is that charts created based on historical data are laid out in front of the analyst. He or she will point to the incidences where a certain pattern occurs and mark them down. The result is a chart that is marked with reoccurring incidences based on criterion such as moving average or trading range breakouts.**

Answer 16

One high level indicator of funds flow is the funds flowing in or out of mutual funds. Another closely related statistic is the percentage of cash (that has yet to be invested) contained in the average mutual fund. A net fund inflow into equity funds, as well as lower cash levels in mutual funds are bullish indicators for the stock market. An indicator that is often used for individual securities is the Money Flow Index (MFI). The MFI is a momentum indicator that is very rigid in that it is volume-weighted, and is therefore a good measure of the strength of money flowing in and out of a security. It compares "positive money flow" to "negative money flow" to create an indicator that can be compared to price in order to identify the strength or weakness of a trend. The MFI is measured on a 0-100 scale and is often calculated using a 14-day period. The "flow" of money is the product of price and volume and shows the demand for a security and a certain price. The money flow is not the same as the Money Flow Index but rather is a component of calculating it. When calculating the money flow, we first need to find the average price for a given period. Since we are often looking at a 14-day period, we will calculate the typical price for a day and use that to create a 14-day average. **Typical Price= Day High + Day Low +Day Close / 3 Money Flow=(Typical Price)×(Volume)** The MFI compares the ratio of "positive" money flow and "negative" money flow. If typical price today is greater than yesterday, it is considered positive money. For a 14-day average, the sum of all positive money for those 14 days is the positive money flow. The MFI is based on the ratio of positive/negative money flow (Money Ratio). **Money Ratio=Positive Money Flow / Negative Money Flow** Finally, the MFI can be calculated using this ratio: **Money Flow Index=100−[100 / (1+The Money Ratio)]** The fewer number of days used to calculate the MFI, the more volatile it will be. TEST TIP: Certainly the above calculation is interesting academically and may be useful for real-world applications. However, for the CFP® Certification Examination, it is the concepts of flow of funds indicators that will be important and it will not be necessary to perform calculations using this model.

Answer 17

An econometric model is a statistical model. This model provides a means of forecasting the levels of certain variables, known as endogenous variables. In order to make these forecasts, the model relies on assumptions that have been made in regard to the levels of certain other variables supplied by the model user, known as exogenous variables. For example, the level of new homes projected to be built next year is a derivative of the level of GDP and interest rates. Therefore, the endogenous variable of housing starts is dependent of the exogenous variables of the GDP and interest rates. An econometric model may be extremely complex or it may be a very simple formula. In either case, it involves a blend of economics and statistics. Economics is first used to suggest the forms of relevant relationships and then statistical procedures are applied to historical data to estimate the exact nature of the relationships involved. Some investment organizations use large-scale econometric models to translate predictions about factors such as the federal budget, expected consumer spending, and planned business investment into predictions of future levels of gross domestic product, inflation, and unemployment. Large-scale econometric models employ many equations that describe many important relationships. Although estimates of the magnitudes of such relationships are obtained from historical data, these estimates may or may not enable the model to work well in the future. When predictions turn out to be poor, it could have been a structural change in the underlying economic relationships or from the influence of factors omitted from the model. Either situation necessitates changes in either the magnitude of the estimates or the basic form of the econometric model, or both. Econometric users usually "fine-tune" (or completely overhaul) such a model from time to time as further experience is accumulated. PRACTITIONER ADVICE: **Keep in mind that there are many assumptions used in economic models. Planners do not help clients chase after past economic events, but rather maintain focus on fundamentals such as asset allocation and rebalancing.**

Answer 18

A buy-and-hold investment strategy involves buying stock and holding it for a period of years. There are four reasons why such a strategy is worth considering. The following is a list of reasons when considering the buy-and-hold strategy: * It aims at avoiding market timing. By buying and holding the stock, the ups and downs that occur over shorter periods become irrelevant. * It minimizes brokerage fees and other transaction costs. Constant buying and selling really racks up the charges, but buying and holding has only the initial purchase charge. By keeping these costs down, the investor retains more of the stock's returns. * It helps postpone any capital gains taxes when you are holding and not selling the stock. The longer you can go without paying taxes, the longer you hold your money, and the longer you have to reinvest and earn returns on your returns. * It helps your gains to be taxed as long-term capital gains. PRACTITIONER ADVICE: **Warren Buffet says his favorite holding period is forever because there would be no taxable event till the end and no transaction fees along the way. Realistically, some people cannot buy and hold forever. There may be a real need for the money, or in many cases, investors cannot stomach the emotional ride of holding on to an investment that fluctuates greatly in the short-term. In reality, investment professionals use a combination of strategies to avoid the inevitable pitfalls of any one strategy.**

Answer 19

Immunization is accomplished by calculating the duration of the promised outflows and then investing in a portfolio of bonds that has an identical duration. In doing so, this technique takes advantage of the observation that the duration of a portfolio of bonds is equal to the weighted average of the durations of the individual bonds in the portfolio. For example, if a portfolio has one-third of its funds invested in bonds with a duration of six years and two-thirds in bonds having a duration of three years, then the portfolio itself has a duration of four years: (1/3)(6) + (2/3)(3) = 4. Consider a situation in which a portfolio manager has only one cash outflow to make from a portfolio: an amount equal to $1,000,000, which is to be paid in two years. Because there is only one cash outflow, its duration is two years. The bond portfolio manager can invest in two different bond issues. The first is a bond issue that has a maturity of three years. The second issue involves a set of bonds that mature in one year. The portfolio manager has the following options: All of the portfolio's funds could be invested in one-year bonds, with the intention of reinvesting the proceeds from the maturing bonds one year from now in another one-year issue. However, doing so would entail reinvestment risks. If interest rates were to decline over the next year, then the funds from the maturing one-year bonds would have to be reinvested at a lower rate than the one currently available. All of the portfolio's funds could be invested in a three-year issue. However, this choice entails interest rate risks as well. The three-year bonds will have to be sold after two years in order to come up with the $1,000,000. The risk is that interest rates will have risen before then, meaning that bond prices, in general, will have fallen and the bonds will not have a selling price that is at least $1,000,000. One proposed solution is to invest part of the portfolio's funds in the one-year bonds and the rest in the three-year bonds. How much should be placed in each issue? Suppose the duration of the three-year security is 2.78 and the duration of the one-year is 1 because it is a discount instrument. We know the proportions (weight) of two debt instruments need to add up to 100% of the portfolio, or converting percentages to decimals, W1 + W3 = 1. We also know that we desire to have a duration of 2 years or (W1)(1) + (W3)(2.78) = 2, where W1 equals the percentage of weight for the one-year duration instrument and W3 equals the percentage weight of the three-year maturity bond with a duration of 2.78. We can use the following equations to solve for the allocation of the two securities to achieve a portfolio that has a two-year duration: PRACTITIONER ADVICE **To immunize a bond portfolio, money managers will match the duration of the portfolio with the investor's time horizon. Passive managers will only match the duration once. Active managers will monitor and trade bonds to ensure that the duration remains consistent with the investor's time horizon on an ongoing basis. The key is that the manager's adjustments are based on the duration and not the maturity of the fixed income securities.**

Answer 20

* Fundamental Analysis seeks the intrinsic value of a stock by forecasting its future earnings revenue and dividends. Fundamental analysis proponents may do this by identifying a company and look at its environment such as industry and country. They can also begin their analysis on the economy as a whole, then an industry, before selecting a company to invest in. * Buy and Hold is a strategy of buying stock and holding it for a period of years. This method prevents the need to time the market or incur the transaction costs for market timing. * Bond portfolio immunization is a strategy where a portfolio manager uses a combination of debt securities with varying durations to produce an average duration that meets an investment objective. * Active Bond Portfolio Management includes contingency immunization, bond swaps, interest rate caps, floors and collars. They are methods to monitor and actively trade debt securities and derivatives in order to attain the desired duration/return. * Efficient Market Anomalies such as the January effect and the Low P/E effect are unexplainable occurrences at various levels of market efficiencies that produce abnormal returns. PRACTITIONER ADVICE: **According to the Efficient Market Hypothesis, there are no advantages available for both technical and fundamental analysis if the market is at semi-strong efficiency. However, to ignore technical or fundamental analysis would increase inefficiency in the market. For example, Fidelity Investments maintains a facility at tremendous costs dedicated to seeking potential value in charts. If all other companies stopped devoting their resources to charting, then Fidelity would have sole competitive advantage in revealing investment opportunities using technical analysis and would consistently outperform the market, thus disproving market efficiency.**

Answer 21

In the first step of the financial planning process, a relationship is established between you and the client. During this step, the client must disclose sensitive personal information about his or her finances. It is important for you to establish a rapport that will make your client comfortable and confident in sharing this information with you. If your clients withhold information from you, it will be difficult for you to help create a financial plan that has the correct asset allocation to help them reach their goals. Individual investors must be willing to reveal intimate facts to their money manager about their age, education, work experience, health, and details about their family and personal life. There is a wide array of goals and constraints that are appropriate for the investments of different types of investors. An important part of the money management processes is to continue discussions with the client to stay abreast of any changes that might occur. In the initial discussions it is important that you and your client discuss: * The client's financial situation, * The length of the client's investment horizon, * The client's tax situation, * Any legal constraints that might be binding on the client's investing activities, * Anticipated cash withdrawals or deposits, and * The client's liquidity needs. CASE-IN-POINT: The information exchange is not a one-way street. In order for clients to gain confidence in you and share their personal financial situation with you, you must prove to them that you are a competent financial planner who has had success helping other clients to reach their investment objectives. You may find yourself listing your credentials in order to gain some of their confidence. It would also be helpful to recite examples of success. At the same time, it would not be helpful to come across as someone who applies the same asset allocation for every client, or who does not pay attention to the uniqueness of his or her client's financial situations. PRACTITIONER ADVICE: **Interviewing clients is a learned skill. How you ask for information and handle the conversation is crucial to getting an accurate portrayal of the client's situation. Experience will allow planners to recognize when to take a client's response at face value and when to probe further.**

Answer 22

Different clients have different goals. Some clients might wish to maximize their average annual rate of return. In contrast, an inflation-conscious client or a retirement planner might have a goal of earning a real (inflation-adjusted) rate of return that averages 2% per year. The goal of another client might be to accumulate a certain dollar amount by a specific date. Institutional investors typically have a wider range of goals than individual investors. **PRACTITIONER ADVICE Goal setting is done during the entire interview process. The planner will need to probe the client to find out what is important to the client, temper expectations, and prioritize them. It is helpful to keep goals realistic and sort them by importance and urgency.** Goals need to be realistic and specific. For example, an unrealistic goal would be, "I want to be rich in a few years." A more realistic goal maybe, "I would like to have sufficient savings to provide a retirement income in 25 years." **CASE-IN-POINT Different people will have different goals. Just because someone is more advanced in age does not necessarily mean they cannot have any long-term goals. They could very well be saving for someone else who will survive them, such as creating an investment portfolio to be held in a Supplementary Income Trust that holds money for the use of a dependent with special nee**ds.

Answer 23

The United States has progressive income tax structures for both corporations and individuals. Progressive income taxes place taxpayers with large incomes in higher tax brackets. As a result, some investment behavior is tax-motivated. For example, progressive income taxes make people with large incomes become interested in municipal bond investments because the coupon interest is tax-exempt in the United States. Estate taxes and Unified Gift and Inheritance taxes are typically of concern for investors who are trying to accumulate wealth and eventually disperse some to their heirs. Estate planning strategies will need to be considered for a client’s long-term goals. For 2022, marginal tax rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%. A person who is in the higher tax brackets may want investments that are tax-exempt for income such as municipal bonds and municipal money market instruments. However, for the wealthiest investors, there is an Alternative Minimum Tax, which ensures they cannot shelter all of their money in tax-exempt investment vehicles and not pay any taxes. **PRACTITIONER ADVICE Everyone enjoys the sound of “tax-free,” but the investment that will produce the highest after-tax return will have the highest tax equivalent yield**. **Tax equivalent yield = Tax free rate/(1 – Tax bracket)**. The long-term capital gains tax is levied for investments held for over one year if the proceeds exceed the purchase price. The maximum tax rate for long-term investments is 20%. Short-term capital gains taxes are for investments held for one year or less than one year and are taxed as part of an investor's income. If there was a net loss, then it can be deducted, up to $3,000 per year. If the amount of the loss is greater than $3,000, then the investor can carry that amount to future tax years, and continue to deduct up to $3,000 per year. Understanding the client’s tax situation is important to designing a portfolio that will produce a desired net tax return.

Answer 24

The expectations of investors can vary and most often they may not get everything they want from their investments. For example, some investors are unaware of the corrosive effects inflation can have; some hope to select only assets that appreciate in price rapidly; and some want their portfolio to be liquidated before every market collapse. It is normal for investors to ignore inflation and to desire eye-popping investments. In such situations, planners must explain what is possible and what is impossible. Some additional topics that you can discuss with your clients to set expectations are: * What is realistic and achievable, * The scope of what the portfolio will attempt to accomplish, * The positive relationship between risk and return, * Market volatility, and * The extreme difficulty and low success rate of market timing. Investors should also be made wary of charts and tables of financial data used in promotional literature. For example, a mutual fund might advertise a high average return earned over a period selected to include unusually good times. Salespeople sometimes will push a product that has done well recently rather than what it might be expected to do in the near term. Wise planners will use scientifically prepared investment indexes and market statistics to educate their clients and help them develop realistic investment expectations. PRACTITIONER ADVICE **The planner must help the client understand what is realistic to expect. Every client wants a tax-free investment that yields 20% with check writing privileges and no downside risk. However, in most investment environments, that type of vehicle simply does not exist.**

Answer 25

* **The plots on the line are the most efficient**. * **Plot below the line – achievable, but not efficient**. * **Plot above the line – not achievable at all**.

Answer 26

**Plotting out Mean variance optimization** – investor is getting an optimal amount of return given a unit of risk they’re willing to take * T bills 6% and Stocks 14% (higher return, higher risk) * **Risk averse will plot on left and lower end of curve** * **Risk tolerant will plot on right and upper end of curve**

Answer 27

One way to ensure asset allocation is continuously updated in accordance to the client's risk tolerance and time horizon is to periodically rebalance the portfolio. There are two typical situations that require rebalancing: * **Time**: As time goes by, the investor's time horizon will shorten. The closer to the time horizon the more conservative the portfolio should be. It is similar to driving on the highway: As a driver approaches an exit, he or she will move from the faster lanes to the slower lanes before ultimately taking the off-ramp. * **Performance**: As the performance of the securities changes, the asset allocation may change accordingly. For example, in the late 1990s, stocks, especially tech stocks, did exceptionally well. Their increased value will skew the stock portion of the portfolio above the original asset allocation proportions. To rebalance the portfolio, an investor may sell off the excess proportion of the stock portfolio and purchase the other asset classes until the asset allocation is back to the original proportions. PRACTITIONER ADVICE **Rebalancing for performance change is a hard sell to a client. You are, in essence, telling the client to sell things that are doing well and buy things that are not doing as well. Although this falls right into the investment strategy of buying low and selling high, most people have trouble letting go of winners until it is too late. In hindsight, if investors did sell some tech stocks in the late 1990s and buy into some bonds, they may have saved themselves from much of the negative returns of the early 2000s.**

Answer 28

* Phase 2: Managing the Money: Requires the investment manager to manage the client's money. This phase begins with the preparation of needed forecasts. Then the investment funds are allocated to asset classes and the appropriate investment orders are executed. This phase ends with a periodic performance report. The investment manager and the client discuss the performance report and, if necessary, update the written policy statement. PRACTITIONER ADVICE **Each investment manager or asset management company will have its own philosophy and software for determining the right asset allocation mix for clients. Although the methods may be different, most questionnaires will center on the investor's goals, liquidity requirements, risk tolerances, and time horizons. Some may ask several questions about the same thing in order to force the client to think of the topic from different perspectives. There are many Internet resources to help investors determine for themselves what asset allocation is right for them.**

Answer 29

* The efficient market theory is one of the most interesting paradoxes in the investing world * In an efficient market, the price of any security will reflect all past and present information available * If this is true, there would be no reason for anyone to seek returns above the market * Studies have shown the US markets to be highly efficient * Since few mutual funds have outperform the markets, it is safe to say that investors of index mutual funds subscribe to this theory * But millions still are spent by active managers on fundamental and technical analysis * Their efforts make it possible for the markets to be efficient * Security analysts spend their time uncovering all available information on a security and then act accordingly. If they don’t do the analysis, then market price will not represent all information available and will be less than perfectly efficient * In seeking to disprove the market is efficient, they actually make it more efficient * This module with discuss the various forms of market efficiency and present test result of the US market

Answer 30

If the price of a security reflects everything that is knowable about the security, we call it a perfectly efficient price. A perfectly efficient price is always equal to the security's value, even though the value may change continuously to reflect the random arrival of new information. In other words, the price and value react in unison to the frequent appearance of news. Smart financial analysts who are active traders will not be able to enrich themselves in a perfectly efficient market because all the securities are priced correctly. Some people are surprised to learn that prices should fluctuate randomly; they think that security prices should move smoothly through time. Prices should not move smoothly, because prices adjust rapidly as the information becomes available. These rapid price adjustments cause not smooth continuity, but randomness in the successive price changes of a security. Randomness means that a trend-like series of small upward (or small downward) price moves occurs rarely, if at all. If the price is going to change, it should change all at once, rather than in a series of small gradual adjustments. Sudden large price moves are desirable, so long as price movements in the opposite direction do not consistently follow them. Large quick price movement is a good sign that the market is not suffering from any learning lags. PRACTITIONER ADVICE **As you recall, there are many variables used to calculate a security's price, such as interest rates, earnings, discount rates, and growth rates. Most of these variables are based on assumptions, leaving room for error. For example, earnings are sometimes quoted based on the trailing four quarters. Others multiply the last quarter's earnings by four. One method assumes that the past year's earnings are indicative of the value of a company. The other assumes that the past quarter's earnings are indicative of the future earnings potential of a company. Neither method is exact. When many analysts are looking at the same company, they will exhaust all probabilities, factors, and assumptions. Therefore, even though the value may not be exact from one analyst, the consensus of all the analysts can come close to the efficient price.**

Answer 31

Observation 2: Investors will do just as well using a passive investment strategy where they simply buy the securities in a particular index and hold onto that investment. Such a strategy will minimize transaction costs. It can be expected to do as well as any professionally managed portfolio that actively seeks out mispriced securities and incurs costs in doing so. Such a strategy can be expected to actually outperform any professionally managed portfolio that incurs unnecessary transaction costs (by, for example, trading too often). Note that the gross returns of professionally managed portfolios will exceed those of passively managed portfolios having similar investment objectives. At the same time, the two kinds of portfolios can be expected to have similar net returns. PRACTITIONER ADVICE: **If markets were truly efficient, then it would be difficult to outperform indexes over the long term. Expenses and taxes would become important variables. Passive investment has the advantage of low expenses and tax efficiency.**

Answer 32

Tests of market efficiency are really joint tests about whether markets are efficient and whether security prices are set according to a specific asset-pricing model. Many tests have been conducted over the years examining the degree to which security markets are efficient. Some general conclusions can be drawn from the most prominent of these studies. **Evidence suggests that U.S. financial markets are highly efficient**. PRACTITIONER ADVICE: **Market efficiency is very difficult to test. Calculating risk-adjusted returns requires assumptions made about discount rates. Interpretation of what is a piece of relevant information is subjective. There will be people who perform well based on luck. Finally, different people may interpret data and charts differently. It is sometimes called data snooping. Some analysts will see one formation in the charts while others see something different.**

Answer 33

* Observations in perfectly efficient markets indicate that abnormal returns cannot be expected regardless of the methods of analysis, strategies, or past performance of investors. * Tests of Market Efficiency use three main methods: event studies on how quickly security prices react to release of information; pattern searches to seek repeating abnormal returns; and performance of professional investors in seeking a consistent high performer. * Anomalies or empirical regularities are commonly related to seasonal effects, small firm or size effects, neglected firm effect, low P/E effect, and the Value Line phenomenon. **TEST TIP: The Efficient Market Hypothesis is an important aspect of the CFP Certification Exam. The most important points to remember are:** * **differentiating among the three forms of the EMH**, and * **knowing the proven anomalies to the EMH**.

Answer 34

The capital market line (CML) represents the linear efficient set in the world of CAPM. All investors will hold a portfolio lying on the CML. It is the efficient frontier when borrowing and lending at the risk-free rate are permitted. It can be described as the most desirable asset allocation line. It denotes the set of most desirable risky portfolios that can be generated by borrowing and lending at the risk-free rate of interest. Assuming homogeneous expectations and perfect markets, the CML, therefore, represents the efficient set. The slope of the CML is equal to the difference between the expected return of the market portfolio and that of the risk-free security, (r⎯⎯M−rf) Divided by the difference in their risks, (σM−0) Or, (rM−rf)/σM As the vertical intercept of the CML is rf, the straight line characterizing the CML has the following equation: rP=rf+[rM−rfσM]σp where r⎯⎯p and σp refer to the expected return and standard deviation of an efficient portfolio. This formula represents the expected return of the portfolio equals the risk-free rate plus the risk premium for the asset. **Two key numbers characterize equilibrium in the securities market**: * The first is the **vertical intercept of the CML, that is, the risk-free rate**. It is often referred to as the **reward for waiting**. * The second is the **slope of the CML**, which is often referred to as the **reward per unit of risk borne**. In essence, the security market provides a place where time and risk can be traded, with their prices determined by the forces of supply and demand. Thus, the intercept and slope of the CML can be thought of as the price of time and the price of risk, respectively. In the example, they are equal to 4% and 1.21, respectively. **Exam Tip: The distinguishing feature of the capital market line is that the denominator is the standard deviation of the market. This will help you recognize the capital market line equation on the CFP® exam.**

Answer 35

* Not likely to have to calculate on exam. If so, drop in variables, and play order of operations * Conceptually could be exam question * SML is looking at a particular security and expected return given a risk free rate * CML takes it a bit further. In the world of CAPM, all risky assets, can be plotted along a line and represent a new efficient frontier * In this calculation, standard deviation is used as the risk factor * Everything on that line represents the most efficient portfolios for a return for a given amount of risk (measured by standard deviation)

Answer 36

* Highly-testable calculation: The Capital Asset Pricing Model (CAPM) * **Security Market Line (SML) is simply CAPM expressed in a graphic form** * Likely will have to calculate * One of the provided formulas – be able to recognize it by sight and recognize that’s what they’re asking for in the question * **Order of operations:** * **Rm – Rf: market return minus the risk-free retur**n * **Multiply by beta** * **Add to risk free return** * And that would be **CAMP – risk free return**

Answer 37

Stephen Ross formulated various arbitrage arguments into a formal Arbitrage Pricing Theory (APT) that uses any number of risk factors. The theory is based on the law of one price, which states that if a security's price is different in different markets, then a riskless profit exists for investors to buy the security from the market with the lower price and sell it in the market with the higher price. ri = a + b1F1 + b2F2 + bkFk + ei Where: ri = rate of return on security i ai = the zero factor: the expected return when all factors = zero Fk = the value of the factor, such as the rate of growth in industrial production ei = random error term In this equation, bi is known as the sensitivity of security i to the factor. It is also known as the factor loading for securityi or the attribute of securityi. The law of one price tells us that assets with equal betas have the same amount of undiversifiable risk and, therefore, should have identical expected rates of return. Furthermore, they should also have identical expected rates of return and intercept terms. The scenario described here is an equilibrium situation in which it will not be profitable to perform arbitrage between assets. When multiple assets are in equilibrium, their Arbitrage Pricing Theory Lines would be identical. The y-intercept and slope are the same for all assets. Every asset that plots above the arbitrage pricing line is underpriced, and every asset that plots below the APT line is overpriced. In a theoretically ideal market, a smart investor might use the law of one price to earn riskless arbitrage profits. By setting up an imperfect hedge with the imbalanced portfolios, the smart investor can create a profit without investing any money or without taking any risk. For example, if two assets have the same sensitivity to a factor but different expected returns, then the investor would buy the one with the higher return while selling the one with the lower return. The proceeds from the sale will pay for the purchase and the return would be the difference between the two securities. TEST TIP **The factors are the distinctive characteristic of the arbitrage pricing theory. If a question on the certification exam begins to talk about factors and sensitivity to factors, it is referring to the APT.**

Answer 38

**C - P = S - PV(X)** C = S - PV(X) + P (Tip: Add P to each side to isolate C) C = S - [ X / (1+r) T ] + P (Tip: Present value of the strike price.) C = 22 - [20 / (1.015)(30/365)] + 3 C = 22 - [20 / 1.0012] + 3 C = 22 - [19.98] + 3 C = $5.02 PRACTITIONER'S ADVICE **The formula in the textbook may look different than the one presented here, in that the text uses an e (which represents a figure to allow for continuous compounding) to calculate the present value of the strike price. The CFA Institute (formerly known as AIMR), as of 2004, began using the simplified version (as present here) in their curriculum. My advice is to learn this simplified version presented in this module.**

Answer 39

**Delta** - Delta measures the impact of a change in the underlying stock price on the value of a stock option. **Delta is positive for a call option and negative for a put option**. * A $1 change to the stock price is approximately equivalent to change in option price by delta dollars. **Eta** - Eta measures the percentage impact of a change in the stock price on the option value. Eta is positive for a call option and negative for a put option. * A 1% change to the stock price is approximately equivalent to change in option price by eta%. **Vega** - Vega measures the impact of a change in the volatility of the stock on the stock option. Vega is positive for both a call option and a put option. * A 1% change to the stock's standard deviation is approximately equivalent to change in option price by vega. **Gamma** - Gamma measures delta's sensitivity to a stock price change. * A $1 change in the stock price causes the delta to change by approximately the amount of gamma. **Theta** - Theta measures the option price sensitivity to a change in time till expiration. * A one-day change to time to expiration will cause the option price to change approximately by theta. **Rho** - Rho measures the option price sensitivity to a change in interest rate. * A 1% change to the interest rate will cause the option price to change approximately by rho. * **TEST TIP: Since the Black-Scholes-Merton-Merton Model is calculated using computer software in real life, it is not as important to know the equation or how to calculate options prices using this model as it is to know how changes in various components of the model affect the price of the option.**

Answer 40

The option pricing model factors listed below illustrate how changes in certain variables will affect the price of puts and calls. * **Price**: Change of share price beyond the parity will affect the price of calls and puts inversely. * As the **price of the stock increases, the call premium increases and the put premium decreases**. * If the **stock price decreases, the opposite will occur**. * **Time**: The **longer the time to expiration, the higher the premium of a call and a put option**. However, the **put premium will level out while the call premium will continue to rise**. * **Risk**: Will affect put and call premiums the same way (directly). The higher the standard deviation, the higher the premium. * **Interest**: Will have an inverse relationship with calls and puts. **As interest rates increase, call premiums will increase but put premiums will decrease**.

Answer 41

When buying or selling common stock, the investor places an order involving a round lot, an odd lot, or both. * In general, round lot means that the order is for 100 shares, or a multiple of 100 shares. * Odd lot orders generally are for 1 to 99 shares. * Orders that are for more than 100 shares, but are not a multiple of 100, should be viewed as a mixture of round and odd lots. Thus, an order for 259 shares should be viewed as an order for two round lots and an odd lot of 59 shares. **PRACTITIONER ADVICE: A block trade is for 10,000 shares. This is typically carried out by institutional traders who make large volume transactions throughout the trading day.**

Answer 42

To ensure that you have a solid understanding of margin accounts, the following topics will be covered in this lesson: * Margin Purchases * Short Sales * Securities Lending Upon completion of this lesson, you should be able to: * Describe margin purchases, * Describe short sales, and * Describe security lending. **PRACTITIONER ADVICE: People often confuse the term margin. When someone talks about buying securities on margin, he or she often refers to margin as the money that is borrowed. The margin portion actually refers to the equity (the portion that is paid for already). So if there was a $10,000 stock purchase with a 60% initial margin requirement, investors must put down $6,000 and borrow $4,000, not the other way around.**

Answer 43

It is maintenance margin that protects the brokerage firm from losing money in situations where the initial margin has not been sufficient to cover the extreme volatility of stock prices. In order to examine the use of maintenance margin in short sales, the actual margin in a short sale will be defined as: **Actual Margin = (short sale proceeds+initial margin) −loan / loan** For short sales, the loan is the current value of the assets held in the account (current price X number of shares). In some cases, there are short sales in which the stock price goes up to such a degree that the maintenance margin requirement is violated and the account is thereby under-margined. One more case is where the stock price goes up but not to such a degree that the maintenance margin requirement is violated. In this case, the initial margin requirement has been violated, which means that the account is restricted. Maintenance margin, in other words, is charged over and above the initial margin, especially in times of volatile markets. This is required to be able to cover the actual margin requirements of an order. **Exam Tip: While it is likely that you will be tested on margin calls and requirements from the long side, it is highly unlikely you will be tested on margin calls/requirements on short transactions.**

Answer 44

* Margin purchases involve purchase of securities by borrowing from brokerage firms to buy securities on margin. The investors are required to maintain a margin requirement with respect to actual margin and initial margin, engage in financial leverage, and pay interest on margin loans. * Short sales involve the sale of securities that are not owned, but rather are borrowed by the sellers. The borrowed securities must ultimately be purchased in the market and returned to the lenders. A short seller must deposit the proceeds of the short sale and initial margin with his or her broker. The short seller must also maintain a minimum actual margin level in his or her margin account or face a margin call. **PRACTITIONER ADVICE: Remember, leverage works both ways. A margin account can maximize an investor's return but also increase the risk exposure.**

Answer 45

Upon completion of this lesson, you should be able to: * State how synthetic long and short positions are created, * Describe the strategies used in portfolio insurance, * Distinguish between covered and naked calls, * Explain the effect of straddles, * List and describe the types and uses of spreads, * Understand the mechanics of a zero-cost collar, * Differentiate between short sale and put, and * Explain replicating portfolios. **Exam Tip: There are many more complicated and advanced options strategies. They are not as likely to be on the certification exam.**

Answer 46

To ensure that you have a solid understanding of tax efficient investing, the following topics will be covered in this module: * Tax Investment Models * Tax Investment Strategies * Tax-Advantaged Accounts **Audio**: **Taxes play a big role in investment returns**. * Take advantage of tax-deferred growth as early as possible. * Investing in tax advantaged accounts. * Investing in tax managed funds or other funds with lower turnover rates. * Investing in tax exempt securities * Offsetting capital gains with losses

Answer 47

All investment earnings are taxed. Depending on how investment earnings are taxed, the investment models can be categorized as the Current Model-investment earnings are taxed currently; Deferred Model-investment earnings are taxed at the end of the investment period; Exempt Model-investment earnings are exempt from explicit taxation; Pension Model-the initial investment is deducted or excluded from gross income, and investment earnings are taxed at the end of the investment period. To ensure that you have a solid understanding of the tax investment models, the following topics will be covered in this lesson: * Current Model * Deferred Model * Exempt Model * Pension Model * Multi-period Strategies Upon completion of this lesson, you should be able to: * Outline the various investment models, * Identify examples to build on the investment model, and * Contrast the various investment models against each other. **TEST TIP The models and formulas presented in this lesson expand on some of the return measurements discussed in other modules of this course. These models serve as the basis for selection of tax investment strategies, but they are not significant for the CFP Certification Exam. It helps to understand the components of the models and how the manipulation of certain variables changes the focus of the after-tax returns.**

Answer 48

The Deferred Model gives the future value of an investment having the following characteristics: * Only **after-tax dollars** are invested (as with the Current Model). * The **earnings on the investment are not taxed annually**, thus they grow at the BTROR. * The **accumulated earnings are taxed at the end of the investment horizon when the investor cashes out of the investment**, thus taxation of these earnings is deferred. The **traditional non-deductible IRA** is a classic example of the Deferred Model. In this case, if the taxpayer or the taxpayer's spouse is covered by an employer-sponsored qualified retirement plan and the taxpayer's AGI exceeds a specified amount, the taxpayer may not deduct contributions to a traditional IRA. Moreover, if the taxpayer's AGI exceeds another threshold, the taxpayer may not contribute to a Roth IRA. Nevertheless, a taxpayer precluded from making deductible contributions to a traditional IRA or contributions to a Roth IRA still may make non-deductible contributions up to $6,000 per year to a traditional IRA with a catch-up allowance of an additional $1,000 if the owner is over 50 years of age, subject to AGI limits (2022). These non-deductible contributions are after-tax dollars. We call this model the Deferred Model because the tax on investment earnings is deferred until the investor cashes out of the investment. This characteristic causes the Deferred Model investment to outperform the Current Model investment given equal BTRORs and constant tax rates. **Practitioner Advice: The terminal value of an investment in a taxable account versus the terminal value of a comparable investment in a tax-deferred account can be substantially different. The tax-deferred account will benefit from the extra income available for compounding due to the lack of annual taxation. Thus, it is recommended that people saving for retirement invest in tax-deferred investment vehicles as early as possible.**

Answer 49

First-in, first-out (FIFO) method uses the first shares purchased as the cost basis. This method is effective if the first shares purchased were the most expensive. The cost of shares is used in the order purchased for determining cost basis according to FIFO method. The oldest shares owed are considered to be the ones that are sold first. This method is the default method that the IRS will assume a taxpayer is following unless otherwise specified in a statement attached to the income tax return. For example, Janet buys the following round lots of StreamVid, Inc.: * 200 shares on January 3, 2009 at $1.50/share * 300 shares on September 5, 2012 at $10.50/share * 200 shares on April 20, 2022 at $9.50/share On September 15, 2022 she sold 400 shares at $10/share. What is her cost basis according to the FIFO method? According to FIFO, she would exhaust the basis of the shares purchased the earliest first: 200 shares at $1.50 200 shares at $10.50 Therefore, the gain/loss for this sale was: 200 shares ($10 - $1.50) = $1,700 200 shares ($10 - $10.50) = -$100 Net gain for the sale = $1,600. Since all 400 shares were held over a year, the $1,600 gain would be subject to long-term capital gains taxes. **PRACTITIONER ADVICE: In the ideal world where an investment increases in value, this would be the least efficient method of determining cost basis. If an investment's value rises over time, then the shares purchased the earliest cost less and would produce the greatest taxable gain.**

Answer 50

The specific share identification implies that specific shares are used to apply against the shares sold. Before selling shares, the shareholder must instruct the broker or fund company regarding which shares are to be sold. These instructions must be given at the time of sale or transfer, not later. The broker or agent must confirm this request within a reasonable time after the sale. This method can be used effectively only if the shareholder has kept accurate records and has followed through on the receipt of confirmations from the broker. It allows the shareholder to control the capital gains taxes that he or she has to pay because this can be determined by selecting the shares to sell. Long term or short term gains can also be controlled. This is the preferred tax basis method for investors who actively manage their portfolio for tax efficiency. **PRACTITIONER ADVICE: This method is the best method for tax purposes because the investor has absolute control over how much the gain from a sale would be. It is also not the most cost effective because of all of the effort that is required for proper record-keeping.**

Answer 51

Mutual funds can distribute dividends and capital gains. Both are taxable. The amount of distribution depends on the nature of the fund. Income-oriented funds, such as bond funds, tax-free bond funds, and money market instruments, will pay a monthly amount. However, stock funds vary in their distribution of dividends. Some stock funds make periodic dividend payments, while others almost never pay any dividends. Qualified dividends and long-term capital distributions will be taxable at the investor's appropriate dividend and long-term capital gains rate, whereas bond interest and short-term capital gain distributions are taxable at the investor's ordinary income tax rate. However, not all dividends from mutual funds are taxable. Some funds hold mortgage pass-through securities such as the GNMA. Funds that hold these assets may, from time to time, include some of the original principal with their dividend payments. Shareholders are not responsible for paying taxes on the return of principal amount. Other funds may hold tax-exempt municipal fixed income securities that pay a federal tax-free income, and, depending on the state of residence of the investor, may also be state and local tax-free as well. State income taxes may exclude the portion of interest derived from, or the percentage of the portfolio made up of direct obligations of, the U.S. government, such as T-Bills, T-Bonds, T-Notes, and GNMAs. There are two kinds of capital gains in mutual funds: * Personal: Incurred by shareholders from their transactions with their mutual fund shares. The personal gain or loss depends on the difference between a shareholder's investment outlay and his or her redemption proceeds. * Distributed: Incurred by portfolio managers from their trades within the portfolio and paid out to shareholders as short-term or long-term distributed gains. **Practitioner Advice: Taxable distributions from mutual funds are reported to shareholders and the IRS by the end of January for the previous year on Form 1099-DIV. Shareholders who sell shares within the year will also receive a Form 1099-B to show their proceeds, and in most cases, will receive an average cost statement to help them establish their cost basis.**

Answer 52

Savings bonds are issued by the U.S. Treasury Department. They are non-marketable securities. This means they cannot be sold or bought from anyone except an issuing and redeeming agent authorized by the Treasury Department. Savings bonds are registered securities, meaning that they are owned exclusively by the person or persons named on them. Interest earned on U.S. Savings Bonds is exempt from state and local income tax. You can also defer paying federal income tax on the interest until the bond is cashed or until it stops earning interest in 30 years. **PRACTITIONER TIP: Since the interest payments of Series EE bonds are accrued and tax-deferred, they do not have to be reported on tax returns. However, if the investor reported it annually, then the interest would be subject to the kiddie-tax bracket rather than reporting it all at once later when the owner may be of a higher tax bracket.**