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Financial Planning - Paraplanner Course > Module 6 - Investment Basics and Strategies > Flashcards

Module 6 - Investment Basics and Strategies Flashcards

1
Q

What is asset allocation?

A

The process of placing percentages of assets (stocks, bonds, and real estate) into a portfolio.

  • decision making process that determines how much an investor invests in various asset classes
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2
Q

Define and describe “cash and cash equivalents”

A

Investments that are short-term in nature and very liquid

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3
Q

Define and describe liquidity

A

The ability to easily convert into cash with little or no loss of principal

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4
Q

List several investment vehicles that could be considered “cash equivalents”

A
  • savings account with a bank / credit union
  • money market accounts and funds
  • certificates of deposit (CDs)
  • stable value funds
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5
Q

Define and describe “money market accounts and funds”

A

Typically pay more interest than a savings account and the funds are very accessible - you can write checks to withdraw funds

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6
Q

What is the difference between money market accounts and money market funds?

A

Accounts are offered by banks and Funds are offered by MF companies.

  • Accounts generally yield less than money market MFs, but accounts have FDIC insurance, whereas money market MFs do not.
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7
Q

What is FDIC Insurance?

A

Federal Deposit Insurance Corporation provides insurance coverage limits on total of all deposits that an account holder has at each FDIC-insured bank.

  • $250k per owner / account for single, joint and certain retirement accounts (like IRAs)
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8
Q

Define and describe certificates of deposit

A

CDs are available at different maturities. As a vehicle for emergency funding, you would want maturities of one year or less.

  • If a CD has to be redeemed early, there would be a penalty involving losing some interest, but not any principal
  • CDs have FDIC / NCUSIF insurance
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9
Q

Define and describe Treasury Bills

A

T-bills are backed by the government. They are issued in terms of 4, 13, 26, and 52 weeks

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10
Q

Define and describe stable value funds

A

Are generally found in retirement accounts and offer higher yields than money market accounts while providing stability of principal

  • not FDIC insured,
  • are pools of money invested in short to mid-term maturity gov’t, corp and mortgage bonds
  • the fund purchases insurance to protect principal
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11
Q

Define and describe equity

A

Equity = ownership / stock ownership

  • when an investor wants to earn money from a company, they can either loan the firm money (by purchasing bonds) or buy a small part of the firm (by purchasing stock).
  • stock is regarded as permanent capital because, unlike bonds, it has no maturity.
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12
Q

What forms does stock ownership take?

A

Public stock ownership - traded on stock exchanges or on the over-the-counter (OTC) market. Shares can be easily bought and sold

Private stock ownership - owned by a limited number of people, stock is NOT traded on any of the exchanges, and the stock may be difficult to buy / sell.

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13
Q

Define and describe different benefits of common stockholder ownership?

A

Common stockholders have dividend rights, voting rights and preemptive rights (the right to purchase to purchase new issue first)

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14
Q

Types of return from common stock

A
  • capital appreciation (growth): as revenue grows, stock prices will rise
  • dividends (income):
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15
Q

List several factors that determine a companies value?

A
  • sales (market share)
  • gross revenue
  • net earnings
  • tangible assets (land, buildings, equip)
  • goodwill (intangible value - name recognition)
  • patents / other creative property
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16
Q

Define and describe “bull market” and “bear market”

A

Bull market - stock market is going up

Bear market - stock market is in decline

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17
Q

How would you calculate a stock’s total return

A

Capital appreciation + dividend

> Tax-Adjusted Return = Return x (1 - tax rate)

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18
Q

Sasha has earned 8% on her 10-year investment to provide a down payment on a house. She is in a 24% federal and a 2% state marginal income tax bracket. Calculate the tax adjusted return on her investment?

A

Tax Adjusted Return:

> Return x (1 - tax rate)
0.08 x (1- .26) = 0.0592 (5.92%)

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19
Q

Sasha has earned 8% on her 4 year investment to provide a down payment on a house, and inflation has averaged 2% during that time. What is her return, adjusting for inflation?

A

Inflation Adjusted Return:
((1 + Return) / (1 + Inflation Rate) - 1)

((1 + 0.08) / (1 + .02) - 1) = 0.0588 (5.88%

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20
Q

What is a “rights offering”?

A

Is commonly used to allow existing shareholders to maintain their proportionate ownership shares in a company by buying newly issued shares before members of the general public

  • often times stockholders who are offered rights may purchase shares below their current market price
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21
Q

What is a “warrant”?

A

Is a certificate granting the owner the right to purchase stock from the issuer at a specified price, normally higher than the current market price.

  • is a L/T investment, giving the investor the opportunity of buying shares at a later date at the exercise price.
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22
Q

Define “maturity date” as it relates to debt

A

The date when principal must be repaid

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23
Q

What do you call debt instruments issued with maturity dates of greater than on year and up to 10 years?

A

Notes

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24
Q

Define and describe a bond

A

Represents money borrowed by the issuer, who has a legal obligation to pay interest and principal when due

  • the total amount of principal paid at maturity is called “par value” of the bond
  • the coupon rate is the annual interest rate paid by the bond issuer, and it determines how much each interest payment will be.
  • if a bond is issued for / trades at less than par value, it’s said to be at a “discount”
  • if a bond trades at a price above par value, it is said to be at a “premium”
  • bond prices have an inverse relationship to interest rates; as interest rates go up, bond prices go down, and vice versa
  • discounts and premiums affect the “yield” earned on the bond, and the yield is called “yield to maturity”
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25
Q

Define and describe “zero coupon bond”

A

Bonds that do not have a coupon rate, and therefore do not make interest payments during the life of the bond.

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26
Q

Who are the three main issuers of debt?

A
  • corporations
  • municipalities
  • US government
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27
Q

What are the two forms of municipal bonds?

A
  • general obligation bonds: unsecured obligations backed by faith and credit of the issuer and its taxing power
  • revenue bonds: serviced by specific revenue-producing projects, such as toll roads and hospitals. These tend to have a higher risk
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28
Q

Define and describe TIPS?

A

Treasury inflation-protected securities

  • Treasury Bills (1yr or less)
  • Treasury Notes (1-10yrs)
  • Treasury Bonds (30yrs)
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29
Q

What is the Consumer Price Index?

A

A monthly measurement of the inflation rate that is calculated by the Bureau of Labor Statistics.

The Bureau of Labor looks at prices for a basket of goods and services and then compares these prices to the same basket from the previous month. Eight basic categories of items in this basket are:

  • Food & Beverage
  • Housing
  • Apparel
  • Transportation
  • Medical Care
  • Recreation
  • Education & Communication
  • Other goods and services
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30
Q

What do you need to keep in mind when calculating bonds?

A
  • most bonds are $1,000
  • most bonds have semiannual payments
  • when a coupon rate is given, the coupon (semiannual pmts) is calculated by multiplying $1,000 by that coupon rate to get the annual payment, then divided by two to find the semiannual payment
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31
Q

How do you calculate the current yield of a bond?

A

Current yield = annual interest (coupon) / current bond price

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32
Q

Glenda owns a corporate bond that is currently trading at $980, and the annual amount paid in interest is $50 per year. What is the current yield of the bond?

A

Current yield = annual interest (coupon) / current bond price

$50/$980 = .051 = 5.1%

33
Q

How do you calculate yield to maturity?

A

solving for “i” in a time value money calculation - calculates interest per year

34
Q

Beta Corp has a 6% coupon bond with a par value of $1,000 that matures in 15 years, and the bond has recently fallen in price to $960. What is the current yield to maturity on this bond?

A

END
#of periods - 2
C ALL

1000 FV
(960) PV
30 PMT (6% coupon is $60 with pmts 2x/yr)
15 N
i = ? (6.42%)
35
Q

How to calculate the current price of a bond?

A

calculating PV in time value of an ordinary annuity (as bond interest pmts are effectively annuity pmts)

36
Q

An Acme Corp bond has a 5% coupon and 10 years left until it matures. If interest rates have increased to 6%, what is the current value of the Acme bond?

A

The 5% coupon would be $50 / year, with semiannual pmts, with 2 pmts per year - $25 twice a year

BEG
#of periods - 2
C ALL

1000 FV
25 PMT
10 N
6 i
PV = (925.61)
37
Q

Define and describe “indenture” as it relates to bonds

A

A legal document with each bond issue that specifies the term of that issue.

The term includes the bond’s coupon rate, maturity date, and other conditions that pertain to the issue.

If any term of the bond’s indenture is not followed, the bond goes into default. (ex - missing a pmt)

38
Q

Define and describe a “call provision” as it relates to bonds

A

allows the issuer of the bond to “call in” and redeem the bond at a predetermined price (“call price”) before its maturity date.

if the call price is higher than face value, the difference is the “call premium”.

39
Q

List the four ways real estate is generally classified

A
  • Land
  • Residential Real Estate
  • Commercial Real Estate
  • Industrial Real Estate
40
Q

What two ways can you invest in real estate - give examples

A

Direct investment - through outright ownership / general partnership

Indirect investment - through a limited partnership, corp, or REIT (real estate investment trust)

  • major difference is control, direct investors have control over mgmt decisions being made about the property
41
Q

Define and describe a “REIT”

A

Real Estate Investment Trust - publicly traded

  • equity REIT: invests in properties
  • mortgage REIT: invests in mortgages
42
Q

What is a benchmark?

A

A basket of stocks / bonds / other asset class that is measured on an ongoing basis.

43
Q

Define and describe “systematic risk” as it relates to investing & give 5 major examples

A

Nondiversifiable risk - part of the system.

P - purchasing power risk (inflation risk)
R - reinvestment risk (risk market interest rates have decreased when pmts from an investment are received - you don’t get as much money)
I - interest rate risk
M - market risk
E - exchange rate risk (currency risk)

44
Q

Define and describe “unsystematic risk” as it relates to investing and give 7 major examples

A

Risks that we can manage - can be reduced through diversification.

Business risk - can a busn operate profitably?
Financial risk - amount of debt a busn has
Credit risk - risk that a bond / preferred stock will be downgraded
Default risk - when a busn can’t meet its obligations
Liquidity risk - converting investment to cash without losing $$
Marketability risk - risk an asset can’t be converted to cash quickly
Event risk - risk stock might be affected by unexpected / damaging event, like a regulatory change, fraud, buyout / merger

45
Q

Define and describe “standard deviation”

A

Most important measure of a security’s risk! It’s a measure of total risk (both systematic and unsystematic) and specifically indicates how much an investment’s returns deviate from its average return over a period of time.

Tells an investor how far from the mean (average) return will an individual security’s return likely vary

The higher the deviation, the wider the range of return (more potential volatility)

The lower the deviation, the narrower range of returns (less volatility)

46
Q

What percentage deviation is 1, 2 and 3 standard deviations?

A

1 SD = 68%
2 SD = 95%
3 SD = 99%

If an investment has a return of 7% and an SD of 5%, then 68% the return will fall within 1 SD = -2% and +12% (7-5 & 7+5).

95% of the time, the return will fall within 2 SD = between -3% and 17% (7-10 / 7+10)

98% of the time, the return will fall within 3 SD = between -8% and 22 (7-15 / 7+15)

47
Q

Define and describe “correlation” as it relates to investing

A

In order to reduce overall risk, you want to have assets that don’t behave the same as each other - they don’t “move” the same.

The lower the correlation between assets, the lower the standard deviation of the overall portfolio. (the lower the SD, the less volatile)

The goal of modern portfolio theory is to achieve the highest level of return for any given level of risk.

48
Q

Define and describe the Sharpe Ratio

A

Calculates your risk-adjusted return.
A higher Sharpe ratio, the greater return (adjusted for risk)

(Portfolio Return - Risk Free Rate) / Portfolio Standard Deviation = Risk-Adjusted Return

49
Q

Define and describe “beta”

A

Measures systematic risk - telling you how volatile an asset is compared to another (typically a benchmark)

A beta of 1 means the asset is just as volatile as the market and will move with the market. If the market moves up 10%, so should the asset. A beta of .8 means, the asset would move up 8%. A beta of 12 means the asset will move up 12%

Aggressive investors will be comfortable with a beta higher than 1, whereas risk-averse investors will prefer betas lower than 1.

50
Q

How would you find risk adjusted return for an asset?

A

Total Return / Beta = Risk Adjusted Return

It’s not just about how much return an asset will produce, but how much risk was taken to achieve that return.

51
Q

Define and describe “duration” as it relates to investing

A

How sensitive is a bond / bond fund to interest rate risk.

Measures the sensitivity of a bond’s price to changes in interest rates (also known as “interest rate risk”)

If interest rates fall, you want a fund with higher duration, because the fund would go up in value

If interest rates rise, you want a fund with a lower duration, because the fund would go down in value

To calculate duration =
interest rate change x duration.
<>

52
Q

Kate believes that interest rates are going to RISE 1%. Which fund would she choose?

Fund H with a duration of 6
Fund J with a duration of 3

A

Fund H > 6 x 1 = 6%. The price of the bond will fall 6%

Fund J > 3 x 1 = 3%. The price of the bond will fall 3%

Kate would choose Fund J with a duration of 3.

53
Q

Harry believes that interest rates are going to FALL 1%. Which fund would he choose?

Fund H with a duration of 6
Fund J with a duration of 3

A

Fund H > 6 x 1 = 6%. The price of the bond will increase 6%

Fund J > 3 x 1 = 3%. The price of the bond will increase 3%

Harry would choose fund H with a duration of 6

54
Q

What are the three investment objectives for investing in mutual funds?

A

Capital grown / appreciation - increase in value of the investment

Income - interest income / dividend income received from the investment

Capital preservation - maintenance of the investment’s value regardless of the market conditions

55
Q

What are the three major advantages of investing in MFs?

A
  • pooling of funds
  • diversification
  • professional management
56
Q

What are the two categories of costs related to investing in MFs?

A
  • transaction costs (costs incurred by buying / redeeming shares)
  • operating expenses (shareholder’s portion of the costs of operating the fund throughout the year)
57
Q

Define and describe “load funds” as it relates to investing?

A

funds that are sold with the assistance of a salesperson and have a sales charge at the time of purchase - load refers to the sales charge

58
Q

Define and describe “expense ratio” as it relates to MFs

A

It’s annual operating expenses divided by its average net assets - it proves an overall disclosure of the annual operating expenses of a fund.

59
Q

List types of bond funds

A

> government: S/T, Intermediate, L/T, mortgage-backed securities, TIPs

> corporate: S/T, Intermediate, L/T, investment grade, intermediate grade, HY junk bonds

> municipal: S/T, Intermediate, L/T, national, single state

> foreign bond: gov’t and corp, developed and emerging markets

> multi-sector: combination of US gov’t, HY corp, and foreign bonds

60
Q

List types of stock funds

A

> Small Cap: companies with market cap up to $1-2 billion

> Mid Cap: companies with market cap up to $5-10 billion

> Large Cap: companies with market cap above $5-10 billion

> Growth: younger, faster growing companies

> Value: older, more established companies (often pay dividends)

> Index: mirror a certain index (like S&P 500)

> Sector: specialized in a certain sector of the market (energy, health, precious metals)

> Global: US and international stocks

> International: non-US

61
Q

List types of blend funds

A

> Growth and income: growth and dividend paying stocks and bonds

> Equity income: higher dividend paying stocks and bonds

> Balanced: 60% stocks / 40% bonds

> Lifestyle: choice of conservative, moderate and aggressive

> Target-date: date based on retirement age of primary investor

62
Q

Define and describe ETFs

A

Company with shares that trade in the secondary market on stock exchanges

  • baskets of securities that primarily track both US and international stock / bond market indexes
  • not actively managed (track indexes and market sectors)
  • low annual expenses
  • tax efficient
63
Q

What considerations should be taken into account when developing an asset allocation strategy?

A
  • level of investment risk
  • past investment experience level
  • required rate of return for a goal
  • tax status
64
Q

Define and describe “diversification” as it relates to asset allocation

A

The mechanism to choose a variety of investments to spread out risk and reduce unsystematic risk

65
Q

Define and describe “correlation” as it relates to asset allocation

A

Investments are correlated if their rates of return move in concert / mirror one another.

  • you want a variety of investments with low correlation, so that if one asset decreases, the others will move in another direction
66
Q

Define and describe “strategic asset allocation”

A

attempts to find the optimal balance of assets in a portfolio that will generate the maximum rate of return for a minimum level of risk over a L/T investment horizon

  • modified infrequently / periodically
67
Q

Define and describe “tactical asset allocation”

A

constant adjustment of the asset class mix in a portfolio to take advantage of changing market conditions.

  • market timing approach to portfolio mgmt to take advantage of perceived market inefficiencies
68
Q

Define and describe “dollar cost averaging” as it relates to investing

A

Purchasing stock based on a preset dollar amount rather than a preset number of stocks.

  • fewer stocks are purchased when price increases and more when price decreases.
  • saves the investor $$ over a time period than purchasing a set number of stocks each mont.
69
Q

Describe key differences between Active and Passive investment strategies

A

Passive - follows an index or buys and holds assets to match the market

Active - actively moves investments to beat the market

70
Q

Describe key differences between fundamental and technical investment strategies

A

Fundamental - uses company ratios and data

Technical - uses market trends

71
Q

Describe key differences between value and growth investment strategies

A

Value - looks for undervalued companies

Growth - looks for fast growing companies

72
Q

What should you take into account when creating an IPS

A
  • Goals
  • Time frame
  • Current assets
  • Ability to take risk
  • Willingness to take risk
  • Liquidity needs
  • Personality
73
Q

Describe similarities and differences between MFs and ETFs

A

Similarities:

  • Pool $$ of many investors
  • Basket of investments
  • Goal is diversification
  • Charge fees

Differences:
MFs: > bought and sold 1x / day > priced once per day > actively managed > higher expenses

ETFs: > traded throughout the day on an exchange > prices fluctuate throughout the day > passively managed > tracks indexes > lower expenses

74
Q

What are four main questions to ask when determining a client’s asset allocation?

A

1) what asset classes should one consider for investment purposes
2) what weights / percentages should be assigned to each asset class
3) what is the allowable allocation range based on the weights chosen
4) what specific securities should be purchased for the portfolio

75
Q

Describe the differences between strategic and tactical asset allocation strategies

A

Strategic:

  • L/T focused
  • Most common
  • Optimal balance of max return and min risk
  • Weights are set
  • Constant mix with periodic rebalancing

Tactical:

  • S/T focused
  • Frequently moving asset classes (overvalued / undervalued)
  • Active security selection
  • Asset changes determined by perceived changes in valuation of asset classes
76
Q

Dana is only six months away from her goal ($100,000) of investing in a business and has done well investing in stocks, bonds, and real estate (she has only a small amount of cash / cash equivalents). What changes in Dana’s portfolio would you recommend as she nears her goal?

A

Dana should begin to put assets into liquid investments (cash and cash equivalents) at opportune times to be able to withdraw those funds for her business opportunity

77
Q

If an investor wanted the highest return he could get with low volatility, based on risk measures, which one of the following would he likely choose:

1) 70% stock portfolio with Sharpe ratio of 0.50, beta of 0.90, and 30% bond portfolio with a duration average of 2.

2) 70% stock portfolio with Sharpe ratio of 0.60, beta of 1.20, and 30%
bond portfolio with a duration average of 6

3) . 70% stock portfolio with Sharpe ratio of 0.20, beta of 1.30, and 30%
bond portfolio with a duration average of 3

A

1) 70% stock portfolio with Sharpe ratio of 0.50, beta of 0.90, and 30% bond portfolio with a duration average of 2.

Sharpe ratio - higher the better, more return per risk

Beta - for low volatility, better to have a beta calculation at 1 or below

Duration - low volatility in bonds is measured by duration, with the lower the number the less volatile

78
Q

Compare and contrast the following aspects of MFs and ETFs

1) pooling funds
2) diversification
3) professional money mgmt
4) trading
5) transparency
6) expenses, transactions, operating costs
7) taxation

A

1) pooling funds (same) - MFs and ETFs pool investor funds to create the benefit of investing in many assets at a relatively low cost
2) diversification (same) - pooling investor funds allows the advantage of better diversification than investors can do on their own
3) professional money mgmt - EFTs require less mgmt than MFs because ETFs track market segment movements
4) trading - MFs are traded end of day, ETFs are traded throughout the day, so ETFs are more liquid, as the asset could be sold more quickly than a MF
5) transparency - ETFs have more transparent portfolios because they are baskets of particular securities
6) expenses - MFs are managed investments, so have fees that include transaction costs, operating expenses, sales charge, redemption fees, other misc expenses. ETFs are traded like stock, so have fewer fees. they can accumulate commission costs through frequent trading
7) taxation - ETFs are generally more tax-efficient than MFs

79
Q

Pick 2 stocks that interest you and look at the historical and present returns (yahoo finance / morningstar). Then check the standard deviation and beta for the investments. Which one is the better investment based on the risk taken?

A

Starbucks (SBUX) and Nordstrom (JWN)

SBUX:
1yr return - (2.25%)
5yr return - 19.51%
10yr return - 15.49%
SD - 2.31
Beta - 0.61
JWN:
1yr return - (8.84%)
5yr return - 0.19%
10yr return - 2.62%
SD - 1.86
Beta - 0.69

Beta - similar
SD - JWN has a lower SD
Need more research to prove

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