Module 2 Chapter Reviews

Question 1

What is the investment policy and what is its purpose?

Answer 1

The investment policy is a set of guidelines for managing the financial assets of a financial plan.

The investment policy has 2 purposes:

1) to provide a foundation of goals, time horizon, and constraints on which the portfolio is constructed.

2) to provide a basis for review, performance evaluation, and adaptation to changing conditions.

Question 2

Why is a long-term perspective essential as an element of investment policy?

Answer 2

The US financial markets have a positive bias over the long term, but is much more unpredictable in the short term.

Question 3

Why is it important that investment policy be clearly defined?

Answer 3

Having a clearly defined investment policy will help the planner avoid errors and reduces the chances of disputes between them and the client.

Question 4

What are the five essential elements of an investment policy?

Answer 4

G.R.A.S.P

G - Goals
R - Risk
A - Asset Allocation
S - Strategic/ Suitable Investments
P - Periodic Review

Question 5

What are the three attributes of a sound investment policy?

Answer 5

• Policy must be realistic
• Policy should have a long-term perspective
• Policy must be clearly defined

Question 6

What are the advantages and disadvantages to stocks?

Answer 6

Stocks offer higher returns than most other asset classes and can even offer an increasing dividends. But, stocks are also one of the most volatile asset classes, therefore they are very risky.

Question 7

Why should stocks be an important element in most retirement portfolios?

Answer 7

Many retirees do not have enough capital to afford retiring without being able to make greater returns to outpace inflation and expenses.

Question 8

What are the advantages and disadvantages of fixed-income securities?

Answer 8

Fixed-Income securities are very safe and have low volatility. but they offer a lower rate of return and have inflation risk and interest rate risk

Question 9

What are the two sources of returns of fixed-income securities?

Answer 9

Return can be made by collecting coupons or capital gains.

Question 10

What are the advantages and disadvantages to cash equivalent investments for retirees?

Answer 10

Cash equivalents are highly liquid and have a high safety of principle, but they offer low returns and have purchasing power risk

Question 11

What are the advantages and disadvantages of real estate for retirees?

Answer 11

Real estate offers good rates of return, but have low liquidity, high transaction costs, and tax reporting responsibilities

Question 12

What are the five types of systematic risk?

Answer 12

P.R.I.M.E.

P - Purchasing power risk
R - Reinvestment risk
I - Interest rate risk
M - Market risk
E - Exchange rate risk

Question 13

Explain standard deviation in terms of investing

Answer 13

Standard deviation is a measure of the risk (volatility) of a holding based on the variations around the mean.

Question 14

Explain beta in terms of investing

Answer 14

Beta is a measure of a securities volatility compare to its benchmark. Beta is a multiplier of the index it is benchmarked

Question 15

Explain duration in terms of investing

Answer 15

Duration measures the sensitivity of a bond’s price to changes in interest rates. High duration means higher volatility and interest rate risk.

Price change (%) = -(rate change) * duration

Question 16

What is the coefficient of variation for a stock?

Answer 16

The coefficient of variation is a relative measure of risk (risk per unit of return) and allows risk comparison among different investments.

Question 17

What is the Sharpe Ratio?

Answer 17

The Sharpe Ratio is a measure of risk-adjusted return. The Sharpe ratio measures the performance of an investment relative to the total risk taken.

Higher sharpe ratio means greater return for each unit of risk

Question 18

What is the Treynor ratio?

Answer 18

The Treynor Ratio measures the degree of systematic risk of an investment/portfolio as measured by beta.

Question 19

What is Jensen’s alpha?

Answer 19

The Jensen’s Alpha compares the expected return (as measured by beta) with the actual return.

Question 20

Describe the purpose of asset allocation.

Answer 20

Asset allocation allows you to meet the clients goals while dampening the volatility of market fluctuations.

Question 21

Explain the two factors that can alleviate concerns for price volatility.

Answer 21

Time and asset allocation.
Longer time horizons reduce the short term volatility risk.
Asset allocation reduces volatility of the overall portfolio.

Question 22

What is longevity risk?

Answer 22

Longevity risk is the risk that retirees will outlive their financial resources.

Question 23

What is a Strategic Allocation?

Answer 23

A strategic allocation is an allocation that is chosen for the long term and rebalanced periodically to allocated funds to underperforming securities (cheap) and reducing exposure to securities with large gains (overpriced)

Question 24

What is a Tactical Allocation?

Answer 24

Tactical asset allocation is an active approach to investing by changing the allocations of a portfolio depending on the market conditions and expectations.

Question 25

What is a Core-Satellite Allocation?

Answer 25

Core-Satellite allocation is a combination of strategic and tactical allocations by allocating 70-80% of the portfolio to the to a strategic allocation, and using the rest to capitalize on market opportunities.

Question 26

What is a managed account?

Answer 26

This is an account managed by a professional money manager who creates a customized portfolio for the client.

Question 27

What is a balanced fund?

Answer 27

A balanced fund is a fund that has a 60/40 asset allocation

Question 28

What is a target retirement fund?

Answer 28

A target retirement account or life-cycle fund is a fund that adjusts risks/return overtime as it gets closer to the stated date to give more return/risk earlier on, but reduce risk/return overtime.

Question 29

What are the benefits to the buy-and-hold strategy?

Answer 29

Buy-and-hold has been found to have returns similar to trading, but have less risk, lower transaction costs, and defers capital gains taxes.

Question 30

What is the efficient market hypothesis?

Answer 30

The efficient market hypothesis states that the current market price has already accounted for all available information and future expectations. Therefore, attempting to find mispriced securities is useless.

Question 31

What is Value Averaging?

Answer 31

Value averaging is when an investor contributes a specific value each period, which changes based on how much the portfolio has gained or lost in that period.

If you contribute 2k each month and the account gains $200, the investor only contributes $1,800. If the account losses $200, the investor must contribute $2,200.

Question 32

What are Ben Graham’s four rules of thumb to value investing?

Answer 32

(1) Buy stocks for 2/3 or less than their net current assets

(2) The earnings-price ratio should be twice the current AAA bond yield

(3) The dividend yield should be no less than 2/3 of the AAA bond yield

(4) Avoid companies that are currently losing money or have greater than 60% debt-to-total-assets

Question 33

List three general guidelines for low P/E investing.

Answer 33

• Select stocks with low P/Es, but have solid performance
• Diversify amongst 15-20 different stocks across 10-12 industries
• Only buy medium-large actively traded listed companies

Question 34

What are some characteristics of growth stocks?

Answer 34

• High profit margins
• EPS growth of +15%
• sales and earnings growth dependant of the market
• small to no dividends
• distinctive product/service
• Above average price to earnings ratio
• high price to book value ratios
• high betas
• high expectation for continued growth

Question 35

What is the small firm effect?

Answer 35

The small firm effect is the anomaly that enables investors in small cap companies to get greater returns than the associated risks explain.

Question 36

What are the four steps of the asset allocation process?

Answer 36

(1) Determine the assets classes that will be represented in the portfolio

(2) Determine the percentage weight of each asset class in the portfolio

(3) Select the securities for the asset classes

(4) REview the portfolio and investment climate

Question 37

What are the advantages and disadvantages of target funds?

Answer 37

Target funds are an easy way to purchase a single fund and let it be, but they are one size fits all. They may not meet your specific needs or risk tolerances.

Question 38

What is a ladder stategy?

Answer 38

Also known as a Staggered Maturity Strategy, equal amounts of bonds are held at different maturities to offset interest rate risk

Question 39

What is a barbell stategy?

Answer 39

The bond portion of a portfolio is split into a long term and short term group. Each group then has staggered maturities similar to the ladder strategy. The goal is to blend short term and long term bonds to create an income stream.