Principles & Strategies When Investing for Retirement

Question 1

Investment Policy Purposes

Answer 1

(1) Provides a foundation of goals, time horizons, and constraints on which the client portfolio is constructed. (2) The goals, time horizons, and constraints provide a basis for periodic review by the client and money manager.

Question 2

Verifying the feasibility of an Investment Policy

Answer 2

(1) Historical Market Data, such as those published by Ibbotson & Associates, are a useful check on how realistic an investment policy is. (2) If client expectations are out of line, these data on past performance can be helpful in educating the client and bringing his or her expectations in line with what can likely be accomplished.

Question 3

Importance of a clearly defined Investment Policy

Answer 3

A clear definition of the investment policy helps the counselor avoid errors and reduces the chance of disputes between the counselor and the client.

Question 4

Elements of Investment Policy

Answer 4

(1) Clear statement of goals, (2) Suitable investment vehicles and strategies, (3) Risk tolerance, (4) Rough asset allocation guidelines, (5) a provision for periodic review

Question 5

Risks of Common Stock

Answer 5

(1) Business Risk, (2) Market Risk

Question 6

Standard Deviation

Answer 6

(1) The standard deviation is a statistical measure of total risk that considers the dispersion of all data points (observations) around the average (mean). (2) In the investment field, assets whose returns exhibit higher standard deviations have higher volatility (risk)

Question 7

Coefficient of Variation

Answer 7

(1) The coefficient of variation is calculated by dividing the security’s standard deviation by its mean return. (2) Therefore, it measures risk per unit of return. The lower the number, the better

Question 8

Beta

Answer 8

(1) Beta is a measure of a security’s volatility relative to a benchmark, such as the market. (2) It is often applied to common stocks. (3) A security with a beta of 1.0 matches the volatility of the market. (4) Beta is a measure of systematic (nondiversifiable) risk. (5) Beta tends to regress toward the mean, or 1, over time.

Question 9

Duration

Answer 9

(1) Duration is a term used to describe the price sensitivity of a bond or bond portfolio to changes in interest rates. (2) The higher the duration, the grater the price volatility. (3) Long-term bonds with small coupons generally have higher durations.

Question 10

Calculating change in bond value using change in interest rate

Answer 10

Duration x interest rate change (not decimal but whole) equals the expected change in the value of the bond.

Question 11

Risk adjusted return measures

Answer 11

(1) Sharpe: a degree of risk as measured by standard deviation used to evaluate performance of a security or a diversified portfolio (2) Treynor: a degree of risk measured by beta used to evaluate performance of a security or portfolio., (3) Alpha: measures the excess return for a given level of risk.

Question 12

Purpose of Asset Allocation

Answer 12

(1) The purpose of asset allocation is to apportion funds in a way that meets the client’s investment goals, and (2) dampens the effect of periodic market fluctuations.

Question 13

Risk Measurement

Answer 13

(1) Variability of returns is one of the most common measured of investment risk.
(2) The standard deviation measures the variation of returns over time, around the average return. (3) Thus, standard deviation is the ideal statistical measure of total risk. (4) The more variable these returns (dispersion around an average) the greater the implied risk.

Question 14

Average Investment Return of Asset Classes

Answer 14

(1) 3.5% T-Bills, (2) 5.4% Intermediate-term government bonds, (3) 5.7% Long-term government bonds, (4) 6.1% Long-term corporate bonds, (5) 9.8% Large company stocks, (6) 11.9% Small company stocks.

Question 15

Factors alleviating volatility concerns

Answer 15

(1) Two common factors that can alleviate retirement investors’ concerns with security price volatility are time and asset allocation. (2) Longer investment horizons can manage greater volatility than short investment horizons (3) Asset allocation can select asset classes that are aligned with both the investor’s investment horizon and his or her tolerance.

Question 16

Longevity Risk

Answer 16

(1) Longevity risk is the risk that a retiree will outlive his or her resources. (2) As such, it is a significant risk for a retiree.

Question 17

Diversification in Portfolio Management

Answer 17

(1) Diversification is the act of acquiring assets with low correlation to each other for the goal of lowering overall portfolio risk. (2) Diversification within stocks can be achieved by selecting 10-15 different stocks representing a variety of industries. (3) Diversification of a portfolio would be accomplished by including different asset classes in the portfolio such as common stock (U.S. and abroad.), bonds, real estate, cash equivalents, precious metals, commodities, etc.

Question 18

Strategic Asset Allocation

Answer 18

(1) Strategic Asset allocation attempts to identify the asset mix that will provide the optimal balance between expected risk and return for a long investment horizon. (2) Once the asset mix is determined and the weights assigned, the portfolio manager tries to maintain that balance.

Question 19

Tactical Asset Allocation

Answer 19

(1) 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. (2) Tactical asset allocation can incorporate sector rotation, market timing, or momentum investing, whereby money is moved from area with below-average performance to areas performing above average. (3) Tactical can also be seen as the opposite of momentum investing in some cases.

Question 20

Asset Allocation Process

Answer 20

(1) Determine asset classes that should be represented in the portfolio. No specific securities are identified at this stage; only general classes of assets. (2) Next, the percentage allocation to each asset class is determined. (3) Security selection, (4) Review of portfolio performance and investment climate.

Question 21

Advantages and Disadvantages of Target Funds

Answer 21

(1) The strategy used by target funds is also called glide path. (2) Advantages is ease of investing. (3) Disadvantages are the “one size fit all” may not be optimal for the investor.

Question 22

Benefits of Buy-And-Hold

Answer 22

(1) 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 and trading. (2) It also results in lower transaction costs and the deferral of capital gains taxes on profits.

Question 23

Contrarian Technical indicators

Answer 23

(1) Short selling, (2) Specialists’ Sentiment, (3) Mutual Fund Cash Position, and (4) Put-call ratio.

Question 24

Short selling

Answer 24

(1) Increasing short selling in a stock indicated a growing herd consensus that the market will decline; when this happens, the contrarian expects the market to increase.

Question 25

Specialist’s Sentiment

Answer 25

Specialists are considered to be the “smart money,” and their increased bullishness in a stock makes contrarians bullish as well, and vice versa.

Question 26

Mutual Fund cash positions

Answer 26

(1) Mutual fund managers are viewed by contrarians as herd animals; (2) when mutual funds have low and decreasing cash positions (indicating managers’ bullishess), contrarians take this as a sell signal; the reverse is true as well.

Question 27

Put-call ratio

Answer 27

(1) High and increasing put-call ratios suggest buying opportunities to the contrarian; (2) low or decreasing put-call ratios suggest the opposite.

Question 28

General guidelines for value investing

Answer 28

(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 companies. (2) Diversify: a 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 the NYSE or AMEX or that are actively traded over the counter.

Question 29

Benjamin Graham’s Value Investing Rules of Thumb

Answer 29

(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) The dividend yield should be no less than two-thirds of the AAA bond yield. (4) Avoid companies that are currently losing money or that have more than 60% debt-to-total assets. (5) Ben Graham maintained that safety of principal was the first requirement of investing.

Question 30

Small-firm effect

Answer 30

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 31

Elements of Small-stock strategy

Answer 31

An investor following small-stock strategy should: (1) be prepared to live with volatility, (2) have a long time horizon (3-5 yrs), (3) diversify to 20-30 different issues, acquires shares over time and on weakness, (4) Avoid turning over more than 30% of a portfolio, (5) look for firms where management has a tangible ownership stake, (6) sell not only if fundamentals change adversely, but also if and when 40% of the company’s shares become owned by institutional investors.

Question 32

Ladder strategy

Answer 32

(1) The ladder strategy, also known as the staggered maturity strategy, spreads equal amounts of the bond holding along different maturities; (2) This strategy avoids large commitments at one maturity, and is intended to help offset interest rate risk. (3) A 10-year ladder strategy entails buying 10-year bonds with staggered maturities.

Question 33

Barbell strategy

Answer 33

(1) The barbell strategy splits the bond portion of the portfolio between a short-term bond series and a long-term bond series; both ends then stagger maturities similar to the ladder approach. (2) The essence of this strategy is to blend short-term and long-term bonds to provide an overall income stream that is acceptable to the client.

Question 34

Negative correlation

Answer 34

Indicated that two investments move in exactly opposite directions, but they do not have to move by the same magnitude.

Question 35

Portfolio Rebalancing

Answer 35

Portfolio rebalancing tightens the range of returns in a portfolio by selling assets that have appreciated the most and buying those that have appreciated the least.

Question 36

Price of a Bond

Answer 36

(1) Present value of income stream and maturity value.