MODULE 2 PRINCIPLES & STRATEGIES WHEN INVESTING FOR RETIREMENT

Question 1

WHAT ARE THE TWO PURPOSES OF INVESTMENT POLICY?

Answer 1

investment policy serves 2 purposes:

(1) provides a foundation of goals, time horizons, & constraints on which the client portfolio is constructed. e.g. the policy may establish the goal of preserving the purchasing power of the portfolio while providing periodic distributions, and it may limit the acceptable securities to large-company stocks & US treasury securities
(2) the goals, time horizons, & constraints provide a basis for periodic review by the client and money manager

Question 2

WHY IS A LONG-TERM PERSPECTIVE ESSENTIAL AS AN ELEMENT OF INVESTMENT POLICY?

Answer 2

US financial markets and many overseas markets have a positive bias in favor of the investor. but this positive bias generally plays out over time

in the short term, the investments that produce sizable returns generally go hand-in-hand with price fluctuations. by taking a long-term view, however, these short-term fluctuations can be ignored.

Question 3

WHY IS IT IMPORTANT THAT INVESTMENT POLICY BE CLEARLY DEFINED?

Answer 3

a clear definition of the investment policy helps the planner avoid errors & reduces the chance of disputes btwn the planner & client. ex.

(1) no securities or mutual funds w/ betas greater than 1.15 will be permitted in the portfolio
(2) only listed stocks may be purchased
(3) the portfolio will not use options or futures except to hedge risk

Question 4

@ A MINIMUM, WHAT 5 ELEMENTS SHOULD EVERY INVESTMENT POLICY CONTAIN? BRIEFLY EXPLAIN/PROVIDE EXAMPLES

Answer 4

(1) a clear statement of the client’s investment goals. goals can be stated in relative terms (e.g. stock returns = the market as a whole, as measured against the S&P 500 index)
(2) a statement identifying the investment vehicles and investment strategies deemed suitable (& unsuitable) for the portfolio. ex. “all corporate fixed-income securities will be A-rated or better,” and “no short selling will be allowed”
(3) a statement of the risk level acceptable to the client, as well as how risk will be managed or controlled (through diversification, rotation from LT to ST bonds under specified conditions, etc). e.g. “the portfolio will reduce risk by investing only in highly diversified stock & bond funds. further, interest rate risk will be limited by investing only in fixed-income securities w/ durations of five or less.”
(4) a statement of how the client’s assets should be roughly allocated among the suitable classes of investments & a statement of the philosophy under which they should be managed. guidelines should be given to the planner as to how the funds should be invested & monitored.
(5) a provision for periodic review. the policy should stipulate that planner & client should meet periodically (e.g. semiannually) to review investment performance & discuss any changes to the client’s situation that would call for a change in the portfolio in the investment policy itself; this may include general allocation guidelines

Question 5

ADVANTAGES VS. DISADVANTAGES OF COMMON STOCKS

WHY SHOULD STOCKS BE AN IMPORTANT ELEMENT IN MOST RETIREMENT PORTFOLIOS?

Answer 5

advantages:

• common stocks have earned higher returns over time than other asset classes
• common stocks have outperformed nearly every asset class by a wide margin
• they offer the prospect of rising dividends over time

disadvantages:
- volatility, which is also higher than most other asset classes (makes many clients reluctant to make large allocations to stocks

*the fact remains that many of these same clients will be unable to accumulate sufficient retirement savings without the greater returns enjoyed by stocks over time. the two major risks for common stock are BUSINESS RISK & MARKET RISK

Question 6

ADVANTAGES VS. DISADVANTAGES OF FIXED-INCOME SECURITIES

TO WHAT 2 SOURCES OF RETURN DO FIXED INCOME OWNERS LOOK?

Answer 6

advantages:

• fixed cash flow stream
• return of principal if held to maturity
• high certainty return w/ high quality securities
• generally low price volatility

disadvantages:
- low-to-moderate ROR
- exposure to inflation (purchasing power risk) due to fixed dollar amount of their interest income & principal
- interest rate risk (as interest rate increase, bond prices decrease)

one type of bond, the Treasury Inflation Protected Security (TIPS), pays a fixed rate of interest & has its principal increase w/ the CPI, thereby providing a hedge against inflation

bond investors look to 2 sources for these returns: periodic interest pmts & capital gains. those interest pmts may be taxable, or if from muni securities, tax-exempt

Question 7

ADVANTAGES VS. DISADVANTAGES OF CASH EQUIVALENT INVESTMENTS

Answer 7

advantages:
(1) short-term (maturities of one year or less) money market instruments that are highly liquid
(2) high safety of principal
(3) provides a place for an emergency fund
(4) provides a temporary parking place for retirement funds when other securities markets are in turmoil
(5) diversification effect on a portfolio

disadvantages:
- low rates of return (purchasing power risk)

Question 8

ADVANTAGES VS. DISADVANTAGES OF REAL ESTATE FOR RETIREMENT INVESTORS

Answer 8

advantages:
-respectable average ROR

disadvantages:

• poor liquidity
• high transaction costs
• tax-reporting responsibilities
• can be overvalued (like any asset), leading to negative returns
• few can afford to diversify across several properties & locations
• alternatives: REITs own various properties *for equity addressed through REITs, which own various properties (equity REITs), mortgages (for income REITs), or both (hybrid REITs)
• REITs trade on organized exchanges & OTC
• one aspect of real estate that is applicable to retirees is the REVERSE MORTGAGE, which provides cash flow to a homeowner w/ significant equity in his home

Question 9

STANDARD DEVIATION

Answer 9

a statistical measure of TOTAL RISK that considers the dispersion of all data points (observations) around the average (mean)

in the investment field, assets whose returns exhibit higher standard deviations have higher volatility (risk)

Question 10

BETA

Answer 10

a measure of a security’s volatility relative to a benchmark, such as the market; a measure of systematic (nondiversifiable) risk

• most often applied to common stocks
• ex. a security w/ a beta of 1.0 MATCHES market volatility
• a security w/ a beta greater than 1.0 exhibits GREATER VOLATILITY relative to the market

Question 11

DURATION

Answer 11

a term used to describe the price sensitivity of a bond or bond portfolio to changes in interest rates

• the higher the duration, the greater the price volatility
• LT bonds w/ small coupons generally have higher durations

Question 12

ASSUME A STOCK HAS A MEAN RETURN OF 11% & A STANDARD DEVIATION OF 8%. WHAT WOULD BE THE RANGE OF RETURNS TO BE EXPECTED FROM THE FOLLOWING?

A. 68% OF THE RETURNS

Answer 12

for 68% of the returns, we would expect the range to be one standard deviation on either side of the mean.

therefore, the range would be (11%-8%) and (11%+8%), or 3% to 19%

Question 13

ASSUME A STOCK HAS A MEAN RETURN OF 11% & A STANDARD DEVIATION OF 8%. WHAT WOULD BE THE RANGE OF RETURNS TO BE EXPECTED FROM THE FOLLOWING?

B. 95% OF THE RETURNS

Answer 13

for 95% of the returns, we would expect the range to be two standard deviations on either side of the mean.

therefore, the range would be (11%-16%) and (11%+16%), or -5% to 27%

Question 14

ASSUME A STOCK HAS A MEAN RETURN OF 11% & A STANDARD DEVIATION OF 8%. WHAT WOULD BE THE RANGE OF RETURNS TO BE EXPECTED FROM THE FOLLOWING?

C. 99% OF THE RETURNS

Answer 14

for 99% of the returns, we would expect the range to be 3 standard deviations on either side of the mean.

therefore, the range would be (11%-24%) and (11%+24%), or -13% to 35%

Question 15

ASSUME STOCK XYZ HAS A STD DEVIATION OF 14% AND A MEAN RETURN OF 10%. WHAT IS THE COEFFICIENT OF VARIATION FOR STOCK XYZ?

Answer 15

0.14 divided by 0.10 = 1.4

Question 16

ASSUME STOCK A HAS A STD DEVIATION OF 8% AND A MEAN RETURN OF 9%. ASSUME STOCK B HAS A STANDARD DEVIATION OF 12% AND A MEAN RETURN OF 8%.

WHAT ARE THE COEFFICIENTS OF VARIATION FOR STOCKS A & B, AND WHICH STOCK PROVIDES THE BETTER RISK/RETURN RELATIONSHIP?

Answer 16

stock A: 0.08 / 0.09 = .88
stock B: 0.12 / 0.08 = 1.5

therefore, stock A offers LESS risk per unit of return and has the better risk/return relationship

Question 17

ASSUME THE STOCK MARKET GOES UP 10%. WHAT WOULD BE THE EXPECTED INCREASES IN THE FOLLOWING STOCKS?

(A) STOCK A HAS A BETA OF .85

(B) STOCK B HAS A BETA OF 1.00

(C) STOCK C HAS A BETA OF 1.15

Answer 17

(a) .85 x 10% = 8.5%
(b) 1.00 x 10% = 10%
(c) 1.15 x 10% = 11.5%

Question 18

WHAT % CHANGE IN THE VALUE OF A BOND WOULD YOU EXPECT FOR BONDS WITH THE FOLLOWING DURATIONS & EXPECTED CHANGES IN INTEREST RATES?

(A) DURATION OF 8, INTEREST RATE CHANGE OF 1.4%

(B) DURATION OF 12, INTEREST RATE CHANGE OF 0.75%

(C) DURATION OF 23, INTEREST RATE CHANGE OF 1.0%

Answer 18

(a) 8 x 1.4 = 11.2%
(b) 12 x 0.75 = 9%
(c) 23 x 1.0 = 23%

Question 19

SHARPE RATIO (1 OF 3 RISK-ADJUSTED RETURNS)

USES STANDARD DEVIATION

Answer 19

to evaluate the performance of a single investment or a portfolio relative to the degree of total risk taken, as measured by its standard deviation

the higher the ratio, the greater the return for each unit of risk

Question 20

TREYNOR RATIO (2 OF 3 RISK-ADJUSTED RETURNS)

USES BETA

Answer 20

measures the degree of systematic risk taken by an individual security or a diversified portfolio, as measured by beta

the higher the ratio, the greater the return for each unit of risk

Question 21

JENSEN’S ALPHA (3 OF 3 RISK-ADJUSTED RETURNS)

USES BETA

Answer 21

measures the rate of return an investor should expect for a given level of systematic risk, as measured by beat.

aka it compares the expected return with the actual return. can be used to assess a manager’s performance.

Question 22

IN WHAT MANNER DOES A PORTFOLIO OF 2 PERFECTLY NEGATIVELY CORRELATED STOCKS BEHAVE?

Answer 22

when 2 stocks w/in a portfolio are perfectly negatively correlated, they move in perfectly opposite directions, so the variability of one stock exactly offsets the variability of the other

Question 23

DESCRIBE THE PURPOSE OF ASSET ALLOCATION

Answer 23

the purpose of asset allocation is to apportion funds in a way that meets the client’s investment goals and dampens the effects of periodic market fluctuations

Question 24

A COMMON CONCERN OF RETIREMENT INVESTORS IS THE VOLATILITY OF SECURITY PRICES. EXPLAIN FACTORS THAT CAN ALLEVIATE THESE CONCERNS

Answer 24

2 common factors that can alleviate retirement investors’ concerns w/ security price volatility:

(1) time - longer investment horizons can manage greater volatility than short investment horizons
(2) asset allocation - can select asset classes that are aligned with both the investor’s investment horizon and his or her risk tolerance

Question 25

LONGEVITY RISK

Answer 25

longevity risk is the risk that a retiree will outlive his/her financial resources. as such, it is a significant risk for a retiree

Question 26

CORRELATION & HOW IT RELATES TO PORTFOLIO MANAGEMENT

Answer 26

w/ respect to market securities, correlation describes the degree to which the returns of 2 securities move relative to each other.

perfectly positively correlated securities, measured as +1.0, move together in lockstep. perfectly negatively correlated securities, measured as -1.0, move in opposite directions and to the same extent.

in portfolio management, correlation is used to achieve effective diversification, with the goal of mixing together assets that are not highly correlated. the combination of different assets with lower correlations produces a portfolio w/ lower risk than would be obtained by an undiversified combination of assets

Question 27

STRATEGIC ASSET ALLOCATION

Answer 27

strategic asset allocation attempts to ID the asset mix that will provide the optimal balance between EXPECTED RISK & RETURN for a LONG INVESTMENT HORIZON. once the asset mix is determined & the weights assigned, the portfolio manager tries to maintain that balance. with fluctuating asset prices, some asset classes will naturally do better than others, unbalancing the portfolio relative to the weights originally assigned to each asset category.

e.g. during a period of growing stock prices & rising interest rates, a portfolio that begins with 50% of the dollar value in stocks & 50% in bonds will quickly become unbalanced, with stock values dominating the portfolio. thus, intervention (w/ the client’s approval) becomes necessary to rebalance the mix to the original strategic balance

Question 28

TACTICAL ASSET ALLOCATION

Answer 28

tactical asset allocation is an active approach that tries to position a portfolio into those assets, sectors, and individual securities showing the most promise of above-average gains.

changes are then made as the prospects for these assets, sectors, and securities change. many approaches can be used in tactical asset allocation.

it can use sector rotation & market timing timing approaches, or it can incorporate momentum investing, whereby money is moved from areas with below-average performance to areas that are performing above average.

tactical asset allocation may also be seen as the opposite of momentum investing, moving money away from the asset category that has been most successful to the one that has been least successful. the theory here is that the most successful asset class has either become fully valued or overvalued, and the least successful asset class has become undervalued.

naturally, caution is advised with any such simple strategy. sector rotation and market timing are typical methods of implementing this approach to asset allocation.

Question 29

CORE-SATELLITE ASSET ALLOCATION

Answer 29

core-satellite asset allocation combines strategic AND tactical asset allocation by dividing a portfolio into 2 parts.

(1) the core, which represents 70-80% of the portfolio and is invested often in index funds or broad-based ETFs (strategic asset allocation); and
(2) the remaining part of the portfolio, the satellite portion, is used to try to take advantage of particular opportunities that add return and/or diversification to the portfolio (tactical asset allocation)

Question 30

TARGET RETIREMENT FUNDS

or “LIFE CYCLE FUNDS”

Answer 30

target retirement funds are mutual funds that are usually a fund of funds that allocate assets among stock, bond and money market funds within the same fund family. the asset allocation is determined w/ a specific year of retirement in mind, such as 2020

Question 31

BALANCED FUNDS

Answer 31

balanced funds have a portfolio mix of bonds, preferred stocks, and common stocks w/ the dual investment objectives of current income and capital appreciation.

as a general rule of thumb, these funds have an asset mix of about 60% stocks and 40% bonds.

balanced funds are considered “total return” funds, since they provide both current income and appreciation. (income + growth)

Question 32

MANAGED ACCOUNTS

Answer 32

a managed account, commonly called a separate account or a privately managed account, is one that is managed by a professional money manager who creates a portfolio tailored and customized to the needs of an individual.

this customization provides much greater portfolio flexibility should the individual’s circumstances, needs or preferences change, because the individual securities are actually held in the client’s name

Question 33

BRIEFLY EXPLAIN EACH OF THE 4 STEPS OF THE ASSET ALLOCATION PROCESS

Answer 33

(1) pick asset classes. determine which asset classes should be represented in the portfolio. this step recognizes the client’s policy directives in terms of risk tolerance, investment goals, requirements for cash distributions, etc. it is important to remember that no specific securities are identified at this stage - only the general classes (stocks, bonds etc)
(2) determine allocation. after asset classes have been determined, the % representation of each asset class in the portfolio should be determined. this is the point at which the allocation formula is made. e.g. 60% stocks, 20% real estate, 20% fixed income securities.
(3) security selection. here, the most suitable individual stocks, bonds, real estate, or mutual funds for the portfolio are identified and acquired.
(4) review the portfolio performance & investment climate. there is an important feedback loop between this review & the first step of the allocation process

Question 34

ADVANTAGES VS. DISADVANTAGES OF TARGET FUNDS

Answer 34

advantages:

• enable investor to invest for retirement in just one fund, automatically allocating between stocks & bonds for the investor
• the longer until retirement, the more that will be invested in stocks, and then as retirement approaches & into retirement, the amount allocated to stocks will decrease, and the amount allocated to bonds will increase (“glide path”)
• ease of investing in just one fund
• allocation is changed automatically over time

disadvantages:

• the “one size fits all” approach may not be the optimum choice for the investor
• the fund may not be in sync with the risk tolerance of the investor

Question 35

BUY-AND-HOLD STRATEGY BENEFITS

Answer 35

evidence has generally concluded that a buy-and-hold strategy of a diversified stock portfolio has produced returns at least as good as strategies based on market timing & trading

it also results in lower transaction costs & deferral of capital gains taxes on profits

Question 36

EFFICIENT MARKET HYPOTHESIS

Answer 36

EMF contends that current market prices reflect all available information about issuers and the future expectations of their investors; therefore, attempting to find mispriced securities in an efficient market is a waste of time

Question 37

DOLLAR COST AVERAGING STRATEGY

Answer 37

a strategy for investing equal dollar amounts regularly and periodically over specific time periods, such as investing $100 on the first day of each month or quarter of the calendar year

Question 38

VALUE AVERAGING STRATEGY

Answer 38

unlike dollar cost averaging, value aveaging does not make equal dollar investments; instead, it aims to have the market value in the account increase by a definite dollar amount at regular & periodic time intervals, such as increasing $500 each month

Question 39

GENERAL GUIDELINES FOR LOW P/E INVESTING (P/E = PRICE TO EARNINGS)

Answer 39

(1) select stocks with low P/Es, but only if the companies have solid performances. many stocks deserve low P/Es because the companies they represent are truly inferior
(2) diversify. a diversified portfolio of low P/E stocks should have an equal weighting in 15-20 different stocks representing 10-12 industries
(3) only buy shares of medium to larger companies that are listed on NYSE or AMEX that are actively traded OTC

Question 40

3 RULES OF THUMB FOR VALUE INVESTING (BY BENJAMIN GRAHAM)

Answer 40

(1) buy stocks for 2/3 or less of their net current assets
(2) the earnings-price ratio (earnings yield) should be twice the current AAA bond yield
(3) avoid companies that are currently losing money or that have more than 60% debt-to-total assets

Question 41

CHARACTERISTICS OF GROWTH STOCKS

Answer 41

(1) high profit margins
(2) earnings per share growth of 15% or more
(3) sales & earnings highly independent of general economy
(4) small dividends, if any (as all earnings are used to finance expansion)
(5) distinctive products or services
(6) above average price to earnings ratios (as much as 2 to 4x that of S&P 500 stocks)
(7) high price-to-book value ratios
(8) high betas
(9) high expectations for continued growth by the investment community

Question 42

SMALL-FIRM EFFECT

Answer 42

the small-firm effect is a market anomaly that enables investors in small capitalized companies to reap returns greater than the associated risks explain

Question 43

WHAT CLIENTS ARE SUITABLE FOR SMALL-STOCK STRATEGY INVESTING?

Answer 43

small stocks are not for everyone, and certainly not for many retirees. they may be suitable, however, for clients with high risk tolerances, entrepreneurial instincts, and long investment horizons

Question 44

LADDER BOND STRATEGY (aka STAGGERED MATURITY STRATEGY)

Answer 44

spreads equal amounts of bond holdings along different maturities; this strategy avoids large commitments at one maturity, and is intended to help OFFSET INTEREST RATE RISK

Question 45

BARBELL BOND STRATEGY

Answer 45

splits the bond portion of the portfolio between a ST bond series and a LT bond series; both ends then stagger maturities similar to the ladder approach.

the essence of this strategy is to blend ST and LT bonds to provide an overall INCOME STREAM that is acceptable to the client

Question 46

CALCULATE THE VALUE OF A BOND W/ A 7% COUPON THAT IS MATURING IN 20 YEARS AND HAS A PAR VALUE OF $1000 AND YTM OF 9%

Answer 46

set financial calculator to 2 P/YR (semiannual bond payments)

20 SHIFT[n] 9[i] 35[PMT] 1000[FV][PV}
DISPLAY: -815.98

if the calculator is set at 1 P/YR, then input i as 4.5 (half of 9%) and n as 40

Question 47

CALCULATE THE VALUE OF A ZERO COUPON BOND MATURING IN 20 YRS, WITH A PAR VALUE OF $1000 AND A YTM OF 9%

Answer 47

set to 2 P/YR

20 SHIFT[n] 9[i] 1000[FV] [PV]
DISPLAY: -171.93
no PMT is entered since it is a zero coupon bond