Series 66: Portfolio / Fixed Income Basics (Portfolio Basics)

The Sharpe ratio measures the:

risk adjusted rate of return relative to portfolio volatility The Sharpe ratio measures the incremental rate of return over the risk free rate achieved in a portfolio relative to the standard deviation (volatility) of the portfolio. If the ratio is positive, then there is a real benefit - extra investment return - for assuming the incremental risk. If the ratio is zero (or in exceptionally difficult economic times, such as a major recession or depression, it can even become negative), there is no benefit to assuming additional risk in the portfolio beyond what a risk free investment such as Treasury Bills will give.

To find the real equity risk premium inherent in a stock portfolio, one would deduct:

risk-free return The equity risk premium in a stock portfolio is the excess of return earned over the risk-free rate of return. Assume that the stock portfolio earns 10% and the risk-free rate of return is 4% (say on U.S. Treasury securities). Then the equity risk premium is 10% - 4% = 6%. Thus, the risk-free return is subtracted from the portfolio's total return to arrive at the equity risk premium.

An investor has a broadly diversified portfolio of blue chip stocks. The use of index options to hedge the portfolio reduces:

systematic risk Index options can be used to hedge a portfolio. If index puts are bought, then a drop in the market lowering the portfolio's value will be offset by a gain in the value of the index puts. This strategy hedges against market risk, also known as systematic risk. Non-systematic risk is the risk that any one security will perform poorly. The larger the portfolio, the lower the effect of non-systematic risk. Timing risk is the risk that trades will be not be performed at the best market prices; interest rate risk is the risk that interest rates rise, forcing bond prices and stock prices down.

The risk inherent in a portfolio that cannot be diversified away is known as:

systematic risk Market risk is the same as systematic risk. It is the risk of the market moving adversely, and one's securities positions moving with the market. This risk cannot be diversified away; but it can be hedged against.

Under Modern Portfolio Theory, the efficient set of investments found by CAPM are those with:

the highest expected return relative to the level of risk assumed Modern Portfolio Theory uses "CAPM" - the Capital Asset Pricing Model - to find the best investments in the market. The efficient set of investments are those that give the highest expected return relative to their risk-class. Risk in the model is based on the standard deviation of returns. The best investments are those that give the highest expected return relative to the level of risk assumed (lower is better). When these "best" investments are plotted out on a graph where the vertical axis is expected return and the horizontal axis is risk, the result is an upward sloping line called the "efficiency frontier." Any investments made that lie on the line or above give the best "bang for the buck" - the greatest return per unit of risk assumed. Those that are below the line are inferior investments.

A customer wants an equity investment with a required rate of return of 3.50% and wants to receive a yearly dividend payment of $3.50. To meet the customer's requirements, the security must cost:

$100.00 If the $3.50 dividend payment is divided by the required rate of return (3.50%), this give a per share price of $3.50/.035 = $100.00.

A customer buys a new issue TIPS with a 3% coupon rate. If the CPI during the first year increases by 2%, the customer will receive annual interest the next year of:

$30.60 TIPS stands for Treasury Inflation Protection Security. The coupon rate at issuance is 3% and the security is issued at par. Each year, the principal amount is adjusted upwards by that year's inflation rate, so that the adjusted principal amount at the end of Year 1 will be: $1,000 x 1.02 = $1,020. The 3% coupon is applied to the adjusted principal amount, so 3% of $1,020 = $30.60 in interest that will be paid in Year 2: If there is inflation each year, the principal is continually adjusted upwards and the annual interest payment will increase. At maturity, the holder is returned the higher adjusted principal amount.

The measure of incremental return earned for taking on incremental risk is:

(Total Return - Risk Free Return) / Standard Deviation The Sharpe Ratio ((Total Return - Risk-Free Rate of Return) / Standard Deviation) measures incremental return earned for taking on incremental risk. Standard deviation is the statistical measure of risk, and what gives this question away is that only Choice A has "Standard Deviation" as part of the answer.

Compute the non-compounded annualized inflation adjusted rate of return for the following investment held for 4 years. Initial Investment Value: $4,000 Ending Investment Value: $3,600 Dividends Received Over The Period: $800 Inflation Rate Over The Period: 4%

+1.50% The original investment is $4,000. Over 4 years, the customer lost $400 on the investment and received $800 in dividends, for a net return of $400, earned over 4 years. Annualized, the customer earned $100 per year on $4,000 invested = 2.50%. However, the rate of inflation over 4 years was 4%, or 1% per year (ignoring compounding). Therefore, the inflation adjusted rated of return over the 4 year period is 2.50% - 1% = 1.50%.

An active portfolio manager generates a return of 17.50% on her equity portfolio that has a beta of 1.50. The expected return of the benchmark market index (beta of 1) is 10%. Assuming that the risk-free rate of return is zero, what is the alpha achieved by the manager?

+2.50% In its most simplistic form, alpha is the excess return of an investment as compared to the risk-adjusted return of the market. To find alpha, the following are compared: The excess actual rate of return given by this investment over the risk-free rate of return.Actual Return of Portfolio - Risk-Free-Return = 17.50% - 0% = 17.50%. The excess return of the benchmark index over the risk-free rate of return:Market Index Return - Risk-Free Return = 10% - 0% = 10%. To compute "alpha" we must compare the rate of return that the "benchmark index" would have given if it had the same "beta" as this portfolio. Since this portfolio has a beta of 1.50 x 10% excess benchmark return = 15% risk-adjusted excess benchmark return of the market index. Since the actual excess return of the portfolio was 17.50%, this portfolio has an "alpha" of "+2.50" - the actual excess return of the portfolio (17.50%) minus the expected risk-adjusted excess return of the benchmark index (15%). This means that, on a risk adjusted basis, an investment in the portfolio gave a 2.50% superior return to the benchmark index. An alpha of more than "0" indicates that the investment outperformed the market on a risk-adjusted basis. A negative alpha indicates that the investment underperformed the market on a risk adjusted basis.

A stock whose price moves down 5% when the market as a whole moves up by 10% has a beta coefficient of:

-.50 A stock with a positive "beta" moves in the same direction as the market; a stock with a negative "beta" moves in the opposite direction to the market. If a stock moves down 10% when the market moves up 10%, it has a beta of -1.00. If a stock moves down 5% when the market moves up 10%, it has a beta of -.50. If a stock moves down 20% when the market moves up 10%, it has a beta of -2.00. There are very few "negative" beta stocks - these are counter-cyclical stocks such as credit collection companies and pawnshops (when times are bad, these stocks do well; and vice-versa).

Compute the non-compounded annualized inflation adjusted rate of return for the following investment held for 2 years. Initial Investment Value: $10,000 Ending Investment Value: $9,800 Dividends Received Over The Period: $600 Inflation Rate Over The Period: 6%

-1% The original investment is $10,000. Over 2 years, the customer lost $200 on the investment and received $600 in dividends, for a net return of $400, earned over 2 years. Annualized, the customer earned $200 per year on $10,000 invested = 2%. However, the rate of inflation over 2 years was 6%, or 3% per year (ignoring compounding). Therefore, the inflation adjusted rated of return over the 2 year period is 2% - 3% = -1%.

If an investment yields 6% at the same time as inflation as measured by the CPI increases by 6%, the inflation-adjusted rate of return is:

0% Inflation-Adjusted return deducts the rate of inflation from the investment return, to approximate the "real rate of return." If an investment yields 6% when the inflation rate of 6%, the inflation adjusted rate of return is 0%.

Compute the non-compounded annualized inflation adjusted rate of return for the following investment held for 3 years. Initial Investment Value: $5,000 Ending Investment Value: $4,400 Dividends Received Over The Period: $900 Inflation Rate Over The Period: 6%

0% The original investment is $5,000. Over 3 years, the customer lost $600 on the investment and received $900 in dividends, for a net return of $300, earned over 3 years. Annualized, the customer earned $100 per year on $5,000 invested = 2%. However, the rate of inflation over 3 years was 6%, or 2% per year (ignoring compounding). Therefore, the inflation adjusted rated of return over the 3 year period is 2% - 2% = 0%.

A customer with $30,000 to invest places $10,000 in Investment A; $10,000 in Investment B; and $10,000 in Investment C. During the course of 1 year, Investment A pays 2% in dividends; Investment B pays 7% in dividends; and Investment C pays no dividends. At the end of the year, Investment A is sold for $10,600; Investment B is sold for $9,200; and Investment C is sold for $9,300. The Total Return on Investment is:

0% Total Return consists of both dividends and asset appreciation. Total dividends collected were +$900 Investment A appreciated by $600, Investment B depreciated by $800, and Investment C depreciated by $700, for a net loss of -$900 on the 3 investments of $10,000 each. The $900 of dividends received were exactly offset by $900 of capital losses. Thus, Total Return is "0" on $30,000 invested.

A customer buys 100 shares of ABCD stock at $23.00 per share. At the end of the year, the stock is valued at $29.53. During the year, the stock paid $.30 in annual dividends. The stock's dividend yield is:

1.02% Dividend yield is based on the current market share price, not on cost of the stock. The formula is: Latest Annual Dividends / Current Market Price = $.30 / $29.53 = .01016 = 1.02% (rounded)

A customer buys 100 shares of ABCD stock at $16.00 per share. At the end of the year, the stock is valued at $12.00. During the year, the stock paid $.30 in quarterly dividends. The stock's dividend yield is:

10.00% Dividend yield is based on the current market share price, not on cost of the stock. The formula is: Latest Annual Dividends / Current Market Price = $1.20 / $12.00 = .10 = 10%

An investment in common stock provides dividends equal to 4% per year and expected long term capital gains equal to 8% per year. For a lower-earning investor in the 30% tax bracket, the after-tax rate of return is:

10.20% Dividends and long-term capital gains are taxed at a maximum rate of 15% for lower earners and 20% for the highest earners. Thus, the after-tax rate of return on the dividends is 4% (100% - 15% Tax Bracket) = 3.4%; and capital gains is 8% (100% - 15% Tax Bracket) = 6.8%. Thus, the after-tax rate of return is 3.4% + 6.8% = 10.2%.

An investment provides a 5.50% semi-annual return over a 2-year time frame. What is the annual rate of return?

11.0% This one is simple, but you must be careful. If the investment is returning 5.50% semi-annually, then is it returning 11% annually. The 2-year time frame has nothing to do with getting the answer!

ABCD stock has a beta of +2. The expected market rate of return is 8% and the risk-free rate of return is 1%. The standard deviation of returns is 3%. Using the Capital Asset Pricing Model (CAPM), what is the expected rate of return for ABCD stock?

15% CAPM finds the "expected return of an investment" using the formula: Expected Return of An Investment =Risk-Free Rate of Return + Risk Premium* *Risk Premium is: Beta x (Expected Market Return- Risk-Free Rate of Return) Basically, the Risk Premium is the excess of the expected market rate of return over the risk-free rate of return multiplied by the risk level of the investment as measured by beta. Because the expected market rate of return is 8% and the risk-free rate of return is 1%, the risk premium is 7% x 2 beta = 14%. Thus, the Expected Return of The Investment is: 1% Risk-Free Rate of Return + 14% Risk Premium = 15%. Note that Standard Deviation has nothing to do with the formula and is a distractor in the question.

A trader purchased 100 shares of XYZ stock at $20 per share. Subsequently, XYZ stock goes to $25 per share and then to $22 per share. During the year, XYZ stock paid a $1 dividend. If the trader is in the 30% tax bracket, what is the total return?

15% Total return is presented before tax - since each customer is in a different tax bracket, the after-tax total return would be different for each person. income + cap gain / cost of security = total return $1 Dividend + $2 Capital Gain / $20 per share = 15% Note that the relevant market price for the capital gain is the current market value of $22 per share versus the original cost of $20 per share - any interim price is irrelevant.

An investor buys 1,000 shares of XYZ stock at $34. It goes to $43 in the next year and pays a $3 dividend. At the end of the year following, the stock is trading at $40 and the stock pays another $3 dividend. What is the total return?

17.7% Total return must be presented on an annualized basis. This stock paid a $3 dividend during each of the last 2 years. Over these 2 years, the stock's price went from $34 original cost to $40 at the end of the second year, for a total capital gain of $6 over 2 years = $3 capital gain per year. income + capital gain / cost of security = total return $3 Dividend + $3 Capital Gain / $34 per share = 17.7% Note that the relevant market price for the capital gain is the current market value of $40 per share - any interim price is irrelevant.

Given the set of the following numbers: 5, 5, 7, 18, 12, 9, 23, what is the range, to the nearest 10th?

18.00 The range is the difference between the highest and lowest numbers in the set. The highest number is 23 and the lowest number is 5, so the difference is 18. The numbers in the set "range" from a low of 5 to a high of 23.

A customer purchases 100 shares of ABC stock valued at $100 per share. After 13 months, the customer sells the stock at $130 per share. During this period, the stock paid $2.00 in cash dividends. If the average long-term capital gains tax rate is 20% and the investor's marginal tax rate is 37%, what is the customer's approximate after-tax rate of return?

23% This stock has a $30 long term capital gain, earned over 13 months. Since 20% of the gain is paid in tax, 80% is kept after tax. 80% of $30 = $24. Furthermore, since the gain was earned over 13 months, to annualize the gain, 12/13ths of $24 = $22.15. Regarding the cash dividend received, current law taxes cash dividends at the long term capital gains rate. Of the $2.00 in cash dividends received, 20% goes to tax and 80% is kept after tax. $2.00 x 80% = $1.60. The total after-tax return is $22.15 + $1.60 = $23.75 / $100 invested = 23.75%. (Note: Current tax law taxes long term capital gains and cash dividends at 15% for lower earners and 20% for the highest earners - and the 37% tax bracket is the highest bracket)

A company has quarterly earnings of $3.00 per share. At the end of the year, it retained $9.00 per share. The company's dividend payout ratio is:

25% If quarterly earnings were $3 per share, then annual earnings = $12. Since $9 per share was retained, then $3 was paid as dividends. The dividend payout ratio is $3 / $12 = 25%.

An investment adviser representative has been reviewing the likelihood that an equity investment will produce the desired return. He has determined that the mean return on the investment is 15%, with a 12% standard deviation, and a 95% probability of occurrence. This means that he would expect the range of returns to be approximately:

3.00% - 27.00% A 12% standard deviation means that the investment return can vary plus or minus 12% from the mean (average) return over the course of a year. With a 15% average (mean) return, it might fall as low as 3% (15% - 12% deviation); or it might rise as high as 27% (15% + 12% deviation).The probability of the return falling in this range is 95%. This has nothing to do with the actual calculation of the range of returns. The "probability" of investment returns looks at historical investment return data to see how much investment returns have varied over the years. Historical investment returns follow a "normal distribution," which when plotted on a graph looks like a bell shaped curve. The mean return is the center of the "bell." Returns over time tend to center around the "mean" - the farther away one gets from the mean (either up or down), the less the likelihood of that return occurring. A 1 Standard Deviation move ( + or - ) encompasses 68% of the data history (the bulk of the bell curve); A move of 2 Standard Deviations ( + or - ) encompasses 95% of the data history; Historically, investment returns have not varied by more than 2 standard deviation moves in a given year. For equities as measured by the Standard and Poor's 500 Index, this has been a maximum variance of: +/-15% that is equal to a 1 standard deviation move with a probability of occurrence of 68%. +/-30% that is equal to a 2 standard deviation move with a probability of occurrence of 95%. Based on this historical pattern, when stock prices dropped by 45% in 2008, the probability of this occurring was only 5%. Just because something has a very low probability does not mean that it cannot occur. By the way, the previous drop of a similar percentage occurred in 1973 to 1974 - so this is actually a pretty rare event!

A customer invests $1,000 over a 10-year time horizon. At the end of 10 years, the investment is worth $4,000. The non-compounded annual rate of return is:

30% The investment of $1,000 is worth $4,000 after 10 years. The return on investment is: $3,000 gain / $1,000 investment = 300% earned over 10 years 300% / 10 years=30% annual non-compounded rate of return

The Statement of Financial Condition of ABC Corporation shows the following: Current AssetsCurrent LiabilitiesCash:$500,000Wages Payable:$1,000,000Accounts Receivable:$1,000,000Accounts Payable:$500,000Inventory:$1,000,000Taxes Payable:$500,000Prepaid Expenses:$500,000Long Term AssetsLong Term LiabilitiesFurniture / Fixtures:$500,000Notes Payable:$1,000,000Real Estate:$1,000,000Goodwill:$500,000Stockholders' EquityCommon Equity$2,000,000Total Assets$5,000,000Total Liabilities and Stockholders' Equity$5,000,000 The Current Ratio for ABC Corporation is:

3:2 The best answer is c. The Current Ratio measures a corporation's ability to pay its bills coming due and is Current Assets / Current Liabilities. Current Assets = $3,000,000 (Cash, Accounts Receivable, Inventory, Prepaid Expenses). Current Liabilities = $2,000,000 (Wages Payable, Accounts Payable, Taxes Payable). The Current Ratio is $3,000,000/$2,000,000 = 3:2, which is the same as 1.5:1.

What is ABC Corporation's Quick Ratio?

4 to 1 The formula for the "Quick" Ratio is: current assets - inventories and prepaid expenses / current liabilities = quick ratio $15,000,000 - $3,000,000$3,000,000=$12,000,000$3,000,000=4 : 1

An investment in a company has a 30% probability of yielding 5%; a 40% probability of yielding 9%; and a 30% probability of yielding -2%. The expected rate of return is:

4.50% To find expected rate of return, apply the probability of each outcome to the investment return associated with that outcome and add them up. Probability(1) Return(2) Expected Return (1 x 2) Outcome 130% x 5% = 1.5% 40% x 9% = 3.6% 30% x -2% = -.6% Total:4.5%

The interest rate that is used as the "risk free" rate of return is the:

90-day Treasury Bill rate The interest rate used as the basis for the "risk free" rate of return is usually the 90-day Treasury Bill rate (since T-Bills are U.S. Government guaranteed and thus AAA rated; and 90-day T-Bills are a very short maturity, so there is almost no market risk). Note, however, that 1-year Treasuries can also be used as the basis for the "risk free" rate of return.

A company balance sheet in 2020 shows the following: Assets. Liabilities Cash $2,000,000Accounts Payable$2,000,000Accounts Receivable$10,000,000Wages Payable$2,000,000Inventory$8,000,000Taxes Payable$1,000,000Furniture/Equipment$2,000,000Bank Loan Due 2025$2,000,000 The company's Current Ratio is:

4:1 The Current Ratio is: Current Assets / Current Liabilities. Cash, Accounts Receivable and Inventory are the Current Assets, totaling $20,000,000. Current Liabilities are all the bills due within 1 year. This includes all the current payables, but does not include the bank loan due 2025, for total Current Liabilities of $5,000,000. The Current Ratio is $20,000,000 / $5,000,000 = 4:1.

An investment adviser representative has been reviewing the likelihood that an equity investment will produce the desired return. He has determined that the mean return on the investment is 20%, with a 15% standard deviation, and a 95% probability of occurrence. This means that he would expect the range of returns to be approximately:

5.00% - 35.00% A 15% standard deviation means that the investment return can vary plus or minus 15% from the mean (average) return over the course of a year. With a 20% average (mean) return, it might fall as low as 5% (20% - 15% deviation); or it might rise as high as 35% (20% + 15% deviation). The probability of the return falling in this range is 95%. This has nothing to do with the actual calculation of the range of returns. The "probability" of investment returns looks at historical investment return data to see how much investment returns have varied over the years. Historical investment returns follow a "normal distribution," which when plotted on a graph looks like a bell shaped curve. The mean return is the center of the "bell." Returns over time tend to center around the "mean" - the farther away one gets from the mean (either up or down), the less the likelihood of that return occurring. A 1 Standard Deviation move ( + or - ) encompasses 68% of the data history (the bulk of the bell curve); A move of 2 Standard Deviations ( + or - ) encompasses 95% of the data history; Historically, investment returns have not varied by more than 2 standard deviation moves in a given year. For equities as measured by the Standard and Poor's 500 Index, this has been a maximum variance of: +/-15% that is equal to a 1 standard deviation move with a probability of occurrence of 68%. +/-30% that is equal to a 2 standard deviation move with a probability of occurrence of 95%. Based on this historical pattern, when stock prices dropped by 45% in 2008, the probability of this occurring was only 5%. Just because something has a very low probability does not mean that it cannot occur. By the way, the previous drop of a similar percentage occurred in 1973 to 1974 - so this is actually a pretty rare event!

An investment generates the following annual returns: Year 1:6% Year 2:4% Year 3:2% Year 4:10% Year 5:8% The median return is

6% Given a sequence of returns, the "median" is the centerpoint return. If the returns are arranged in ascending order, they are: 2%, 4%, 6%, 8% and 10%. The centerpoint number is 6% - the median.

An investor buys a security at $95 per share. The stock rises to a high of $105 and ends the year at $99 per share. The stock paid a $3 dividend during the year. What is the investor's total return?

7.37% income + cap gain / cost of security = total return $3 Dividend + $4 Capital Gain / $95 per share = 7.37% Note that the relevant market price for the capital gain is the current market value of $99 per share versus the original cost of $95 per share - any interim price is irrelevant.

A customer buys a TIPS at par with a 3½% coupon. Inflation stays at 4% over the life of the security. What is the total return on the investment?

7½% Treasury Inflation Protection Securities (TIPS) give a fixed coupon rate (3½% in this example), but they also adjust the principal value of the bond up each year for inflation (4% per year in this example). At maturity, the investor gets the inflated principal amount. The Total Return on this TIPS would be 3½% annual income + 4% annual gain = 7½%.

A company has quarterly earnings of $2.50 per share. At the end of the year, it retained $2.00 per share. The company's dividend payout ratio is:

80% If quarterly earnings were $2.50 per share, then annual earnings = $10. Since $2.00 per share was retained, then $8 was paid as dividends. The dividend payout ratio is $8 / $10 = 80%.

An investment adviser has managed a portfolio that has averaged an annual total 12% rate of return. Of the 12% total return, 3% was from dividends and interest earned and 9% was from capital gains on appreciated securities positions sold. During the investment time horizon, inflation averaged 3% per year. The investment adviser's real "total" return is:

9% The investment adviser produced an annualized total return of 12%, but because the inflation rate over that time period was 3%, the real rate of return was 12% - 3% = 9%.

When making an investment decision using CAPM, the interest rate that would be used as the minimum hurdle rate is the:

90 day Treasury Bill rate The Capital Asset Pricing Model (CAPM) finds the expected rate of return of an investment, based on the investment generating the risk-free rate of return plus a risk premium. The risk free rate of return would be the rate for a Treasury security with a maturity that approximates the life of the investment. This would be the minimum return necessary to make the investment (also called the "hurdle rate" - as in clearing a hurdle in racing) if it was deemed to be "risk-free." Because rates increase as maturity lengthens, the lowest interest rate risk free security given as a choice is the 90 day Treasury Bill rate. A very short term safe investment would have to give an expected return that is greater than the 90 day Treasury Bill "risk-free" rate of return in order to "clear the hurdle" and be chosen as an investment instead of the short-term Treasury Bill.

A portfolio of securities with a beta of 1 has produced an average annual return of 12%. Which investment should the portfolio manager NOT consider adding?

An investment with a 20% growth rate and a beta of 2 The portfolio has generated a 12% return without taking on extra risk (the portfolio beta of 1 is at the market risk level of 1). Any investment that yields less than 12% on a risk-adjusted basis would lower the overall portfolio performance. To risk-adjust the return of each investment offered, divide the investment return by that investment's beta. Any investment that yields less than the 12% portfolio return is a bad one for the portfolio. Choice A: 7.8% /.6 Beta = 13% risk adjusted returnChoice B: 15.4% /1.2 Beta = 12.833% risk adjusted returnChoice C: 20% /2 Beta = 10% risk adjusted returnChoice D: 26% /2.1 Beta = 12.38% risk adjusted return

The formula for Total Return is:

Annual Income + Annual Capital Gain / Original Investment Total return takes into account the 2 components of an investor's return - dividend or interest income; and any capital gain or capital loss in the investment (annualized). These dollar values are added and then divided by the original investment amount to arrive at Total Return as a percentage.

The formula for Return on Investment (ROI) is:

Average Annual Cash Flow / Initial Investment Outlay Return on Investment is a simple measure that takes an initial investment and shows how well it performs. The annual cash flows generated by the investment are averaged, and divided by the original investment amount. For example, assume that $1,000 is invested, and that investment is expected to generate cash flow of $100 in the first year, $200 in the second year, and $300 in the third year, at which point the $1,000 original investment will be returned. The average annual cash flow is $100 + $200 + $300 = $600/3 years = $200 per year. Since $1,000 was invested, the ROI is $200 / $1,000 = 20%.

All of the following are needed to calculate the Sharpe Ratio EXCEPT:

Compound value of a sum The Sharpe Ratio is: rate of return - free risk ROR / standard deviation Since standard deviation is a risk measure of variability of return, Choice A is the denominator in the equation. Choices B and D, the actual rate of return on an investment and the rate of return on an investment with zero risk, are in the numerator of the ratio. Choice C - the compound value of a sum, has nothing to do with the Sharpe Ratio.

"High Risk Investment = High Return Investment" "Low Risk Investment = Low Return Investment" This is an example of:

Correlation When looking at the world of investments, there is a correlation between risk and return. Low risk investments give lower returns, but have a low risk of loss. High risk investments give high returns, but have a high risk of loss. So the best answer to this question is that the question illustrates "correlation." Efficient market theory states that market pricing is "efficient" and that no one can do better than the market over a long-term investment time frame. Duration is a measure of bond price volatility. Monte Carlo simulation is a computer-based method to test thousands of probable outcomes to a set of investment variables.

What ratio would be used to evaluate a company's ability to pay off its short term debt?

Current Ratio The key word here is "short" term debt, which is debt that must be repaid within 1 year. This is a current liability. The ratio that measures a company's ability to pay off its bills coming due in 1 year is the Current Ratio - the ratio of Current Assets / Current Liabilities.

All of the following are components of the Capital Asset Pricing Model EXCEPT:

Delta CAPM (Capital Asset Pricing Model) attempts to find the Expected Return of an Investment by breaking the return down into 2 components. These are the Risk-Free Rate of Return and the Risk Premium. The Risk Premium increases with the risk of that investment. The risk premium is the "beta" of the investment times the excess of the expected market rate of return over the risk-free rate of return. The higher the "risk" as measured by "beta," the higher the expected return of that investment. Delta has nothing to do with CAPM.

The rate of return that an individual investor earns over time in a mutual fund, including the timing of cash inflows and outflows, is the:

Dollar Weighted Average Return Dollar weighted average return is most often used when evaluating a specific investor's mutual fund return. It is the return achieved, accounting for the timing of all cash flows (deposits) into the fund and all cash redemptions from the fund made by that investor. It is the same as the Internal Rate of Return, and will vary with the timing of each investor's deposits and withdrawals. Because investors often "chase" past performance, they will buy a fund "too late" (after the fund has posted its best performance and now enters a period of lesser performance) and will sell "too soon." Thus, for the individual investor, dollar weighted average return is often lower than time weighted average return. In contrast, time weighted average return is the measure used for mutual fund performance charts (Total Return, which shows dividends and capital gains as continually reinvested). It reflects the growth that would be achieved from a 1-time investment into the fund and then holding that investment over time - this is a buy and hold strategy. This method is consistent when comparing one fund's performance to another fund's performance.

A customer, age 30, believes that equity investments for growth are the best choice for his long-term investment goals. He does not believe that asset managers can outperform the market over long time periods and doesn't wish to pay for them. The best recommendation for this customer is the purchase of:

Equity Index Fund Shares This customer believes in efficient market theory - that asset managers cannot outperform the market. The best recommendation is an index fund, since these have much lower expenses than actively managed equity funds, such as a high tech fund. Since he believes that you can't do better than the "market," this is the best investment because its expenses are low, so returns are not eroded. Bond funds are not appropriate, since he is young and wants an equity investment for growth

The weak form of efficient market theory states that: I historical stock prices have no validity for predicting future stock price movements II historical stock prices have a strong correlation to future stock price movements III technical analysis cannot be used to improve investment returns IV fundamental analysis cannot be used to improve investment returns

I and III Efficient market theory basically states that markets are efficient at pricing stocks, and that over a long time frame, an investor cannot outperform the market. It is the economic argument used for index funds. There are 3 "forms" of efficient market theory: Weak Form: States that prices reflect all past publicly available information, but that this has no validity for predicting future price movements. It essentially states that price movements are random. This implies that technical analysis is basically useless to improve returns, but fundamental analysis still has potential value. Semi-Strong Form: States that prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information. This implies that anyone with inside information has an inherent advantage and can profit by trading on it. Strong Form: States that prices respond rapidly to both publicly available and private information, so that no one can profit by trading on this information. Most people subscribe to the "semi-strong" version of this theory.

Growth companies typically have: I low dividend payout ratios II high dividend payout ratios III low P/E ratios IV high P/E ratios

I and IV Growth companies are characterized by high price-earnings ratios and low dividend payout ratios. Mature companies are characterized by low price-earnings ratios and high dividend payout ratios.

Mutual fund performance charts show: I Time Weighted Average Return II Dollar Weighted Average Return III a return that is affected by investor cash inflows and outflows IV a return that is not affected by investor cash inflows and outflows

I and IV Time Weighted Average Return is used by mutual funds on their performance charts to show average annual investment returns. It measures how well the fund manager performed in increasing the dollars that have been invested. Additional cash moving into the fund or out of the fund does not affect the computation. This is the average annual return that would be provided from a "buy and hold" strategy. Dollar Weighted Average Return is the same as the Internal Rate of Return. It is the discount rate that takes all of the cash flows from the investment. Dollar Weighted Return takes into account the impact of cash inflows and outflows from purchases and sales as well as growth in assets. The classic comparison of these 2 returns is where a fund receives a large cash inflow after a period of superior performance (which attracted the new investors to the fund) and then suffers a period of poor performance. Time Weighted Average Return shown over the following periods will be much higher than the Dollar Weighted Average Return experienced by the new investors. For example, $100 is invested in a fund at the beginning of the year with a $10 per share NAV = 10 shares purchased. After 6 months, the NAV per share increases to $20 per share and the happy customer invests another $100 (5 more shares). At the end of the year, the NAV falls back to $10 and the investor sells all 15 shares. In this example, the Time Weighted Average Return will be 0% (because the NAV per share was the same at year beginning and year end). However, this customer invested a total of $200 and sold the shares for $150 at year end, experiencing a $50 loss. This equals an annualized dollar weighted average return (IRR) of approximately -25%. If the investor did not make the additional cash deposit at mid year and did not sell the shares at year end, then the 2 measures would have been the same.

Time Weighted Average Return: I is the return measure used for mutual fund performance charts II assumes investment of a fixed amount, ignoring additional deposits or withdrawals of cash at different points in time III is the same as Dollar Weighted Average Return IV allows for accurate comparison of one fund's performance to that of other funds

I, II and IV Time weighted average return is the measure used for mutual fund performance charts (Total Return, which shows dividends and capital gains as continually reinvested). It reflects the growth that would be achieved from a 1-time investment into the fund and then holding that investment over time - this is a buy and hold strategy. This method is consistent when comparing one fund's performance to another fund's performance. In contrast, Dollar weighted average return accounts for all cash flows (deposits) into the fund and all cash redemptions from the fund made by that investor. It is the same as the Internal Rate of Return, and will vary with the timing of each investor's deposits and withdrawals. Because investors often "chase" past performance, they will buy a fund "too late" (after the fund has posted its best performance and now enters a period of lesser performance) and will sell "too soon." Thus, for the individual investor, Dollar weighted average return is often lower than Time weighted average return.

Which of the following are components of common stockholders' equity? I Common at Par II Capital in Excess of Par III Retained Earnings IV Intangibles

I, II, III If a corporation sells stock at a price above par value, the par value received is shown on the balance sheet as "par value," while the excess funds are credited to the corporation's capital surplus account. Retained earnings and earned surplus are different names for the same account - corporate earnings that are not paid out as dividends are credited annually to retained earnings; this is technically owned by the common shareholders. Intangibles are assets of a corporation, such as the value of copyrights, patents or trademarks. They are not a component of common stockholders' equity.

Which statements are TRUE? I Alpha measures a stock's price volatility relative to the market as a whole II Alpha measures a stock's price volatility relative to stock specific (non-market) factors III Beta measures a stock's price volatility relative to the market as a whole IV Beta measures a stock's price volatility relative to stock specific (non-market) factors

II and III "Alpha" measures the portion of an investment's return arising from "stock specific" risk - that is, the portion that of the return that is not variable with the market as a whole. It takes the risk level assumed by that investment for the return achieved and compares it to the benchmark index return, which is "beta-adjusted" to the same risk level. If the portfolio manager achieved an excess return, this is a "positive" alpha and the portfolio manager added value. If the portfolio achieved a lower return, this is a "negative alpha" and the portfolio manager produced an inferior return as compared to the beta-adjusted benchmark return. Beta measures covariance with the market as a whole - a stock with a "beta" of 1.30 means that if the market rises by 10%, the stock should rise by 30% more, or 13%. Delta and Gamma are measures of options premium volatility.

A defensive stock is characterized by: I earnings variability due to changes in economic growth II no earnings variability due to changes in economic growth III a stock price that tends to move in the same direction of the market as a whole IV a stock price that tends to move independently of the market as a whole

II and IV A defensive stock is one that is unaffected by the economic cycle. The classic defensive stocks are food, pharmaceuticals, tobacco, and beer.

The strong form of efficient market theory states that: I stock prices instantaneously reflect all publicly available information II stock prices instantaneously reflect all public and non-public information III insiders have an inherent advantage when making investment decisions IV insiders have no advantage when making investment decisions

II and IV Efficient market theory basically states that markets are efficient at pricing stocks, and that over a long time frame, an investor cannot outperform the market. It is the economic argument used for index funds. There are 3 "forms" of efficient market theory: Weak Form: States that prices reflect all past publicly available information, but that this has no validity for predicting future price movements. It essentially states that price movements are random. This implies that technical analysis is basically useless to improve returns, but fundamental analysis still has potential value. Semi-Strong Form: States that prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information. This implies that anyone with inside information has an inherent advantage and can profit by trading on it. Strong Form: States that prices respond rapidly to both publicly available and private information, so that no one can profit by trading on this information. Most people subscribe to the "semi-strong" version of this theory.

The Efficient Market Theory states that: I undervalued securities should exist II undervalued securities should not exist III overvalued securities should exist IV overvalued securities should not exist

II and IV The "Efficient Market" Theory holds that prices of securities in the market fully reflect all publicly available information, so that undervalued or overvalued securities should not exist. Thus, securities selection based on any type of analytical method is irrelevant. In reality, most individuals believe that the market is only "partly" efficient in pricing securities - so that undervalued and overvalued securities will always exist. These could be identified by both fundamental and/or technical analysis.

When looking at the Price/Book Value ratio of a corporation, which statements are TRUE? I The numerator on the equation is based on liquidation value II The numerator in the equation is based on market value III The denominator in the equation is based on liquidation value IV The denominator in the equation is based on accounting value

II and IV The Price/Book Value Ratio of a corporation is the company's Market Price (per share) / Common Stockholders' Equity (per share). While the "price" is the market value per share, book value is simply the accounting value of common stockholders' equity. Common stockholders' equity is based on accounting as of the date each transaction happened, which could be years in the past. Thus, if the market values of those assets or liabilities booked years in the past have moved dramatically, then "book value" really has little meaning.

Which of the following is NOT a measure of volatility?

Interest rate The interest rate is a measure of return on a fixed income investment. The beta coefficient measures the rate at which a stock price moves relative to the market as a whole; and thus is a risk measurement (stocks that move faster are great when they go up; but really are painful when prices go down). Beta is a "correlation coefficient" because it shows how a single stock's price movements correlate to the market's price movements. Standard deviation measures the potential variance of a security's expected return - the greater the standard deviation, the greater the risk of lower (and higher) returns on that investment.

Which item is used when computing a corporation's Current Ratio?

Inventory The Current Ratio is: Current Assets / Current Liabilities. It is a measure of liquidity, because it looks at whether the company can pay its current bills as they come due. Cash, Accounts Receivable and Inventory are the primary "Current Assets." Net Working Capital is Current Assets - Liabilities. Net Worth is All Assets - All Liabilities. Sales are found on an income statement, not on a balance sheet.

Which of the following is a computer-driven analysis of possible portfolio returns that can be achieved based on varying factors?

Monte Carlo Simulation Monte Carlo simulation is a computer-driven "decision-tree" analysis of possible portfolio returns that can be achieved based on varying factors, such as differing future interest rate levels; equity return levels; inflation rate levels, etc. It assesses the probability of getting the desired portfolio return over a long time horizon, during which these variables can change thousands of times.

A consumer goods company has a Debt/Equity Ratio of 10. Which statement is TRUE?

This company might not be able to generate enough cash to pay its debts The Debt/Equity ratio examines how leveraged the company is. Leverage is the use of debt in a company's capital structure. Because interest on debt is typically fixed rate and must be paid in both good times and bad times, if the company runs into a rough patch, it might not be able to pay the interest on its bonds if it has a large amount of debt. A Debt/Equity ratio of 10:1 is extremely high. Capital intensive industries (like utilities) use a lot of debt in their capital base because the interest is deductible and their earnings are fairly stable. However, their ratios rarely exceed 2:1. So this company is in real trouble and probably won't be able to pay the interest and principal on its debt!.

The potential to earn interest on money which affects its relative value is known as the:

Time Value of Money $100 today is worth more than $100 tomorrow. The reason is known as the "time value of money." The initial $100 could be invested in something which would make the investment "grow." Specifically, the "time value of money" is the potential to earn interest on money which affects its relative value. The productivity of money is known as its time value.

An individual is considering leasing a new automobile. Which quantitative method is used to calculate the monthly payment?

Time value of money A monthly lease payment consists of 2 components - the monthly depreciation amount and the cost of the money borrowed to finance the lease. Since the borrowing charge is the interest rate on a loan, based on the number of years that the car will be leased, this computation uses the "time value of money" to compute the compound interest paid on the financed amount. The Rule of 72 is an oversimplified rule that states that if one takes the interest rate being earned on an investment and divides it into 72, then the result is the number of years that it will take for the investment to double in value. For example, if an investment earns 10%, then it will take 72 / 10 years = 7.2 years for the investment value to double. Net present value takes future cash flows and discounts them by today's interest rate to arrive at today's "net present value" (essentially, this is the opposite of compound interest). Internal rate of return is the interest rate needed to discount future cash flows to "0" - it is the true yield to maturity of an investment.

The formula for Net Worth is:

Total Assets - Total Liabilities In contrast, (Current Assets - Current Liabilities equals Net Working Capital.)

Which statement is TRUE about claim priority in a corporate liquidation?

Unsecured creditors are paid before bondholders The priority of claim to corporate assets in a liquidation is: Secured creditors, unpaid wages and taxes, trade creditors (these are all unsecured creditors), unsecured bondholders, preferred stockholders, common stockholders.

Which form of efficient market theory states that one cannot detect mispriced assets and consistently outperform the market through technical analysis of past prices?

Weak Form Efficient market theory basically states that markets are efficient at pricing stocks, and that over a long time frame, an investor cannot outperform the market. It is the economic argument used for index funds. There are 3 "forms" of efficient market theory: Weak Form: States that prices reflect all past publicly available information, but that this has no validity for predicting future price movements. It essentially states that price movements are random. This implies that technical analysis is basically useless to improve returns, but fundamental analysis still has potential value. Semi-Strong Form: States that prices respond rapidly to publicly available information, so that no potential gains can be made by trading on that information. This implies that anyone with inside information has an inherent advantage and can profit by trading on it. Strong Form: States that prices respond rapidly to both publicly available and private information, so that no one can profit by trading on this information. Most people subscribe to the "semi-strong" version of this theory.

A customer is told by a bank that his investment will pay interest at the rate of .3% per month. This would be the same as telling the customer that his or her:

annual percentage rate is 3.6% The bank is paying interest at the rate of .3% per month. This is the same as an annual percentage rate of .3% x 12 months = 3.60%. The annual percentage yield would be somewhat higher than 3.60% due to the fact the compound interest earned on the monthly interest payments received would increase the annual yield slightly.

All of the following are required to find the future value of an investment EXCEPT:

anticipated interest rate volatility To find the future value of a sum, simply take the sum's present value and multiply it by (1 + Growth (or Interest) Rate) for each year of the investment's time horizon. For example, a 3 year investment of $100 at a 5% growth rate will grow to $100 x 1.05 x 1.05 x 1.05 = $115.76 at the end of 3 years.

Portfolio Total Return A5% B8% C12% D7% If the "mean" of the 4 portfolio returns is calculated as 8%, this is:

arithmetic mean The arithmetic mean is the simple "average" of the 4 returns. 5% + 8% + 12% + 7% = 32 / 4 = 8% mean or an 8% average return. Standard deviation of investment returns is computed by comparing all of the investment returns against the "average" investment return. The more broadly dispersed the investment returns are as compared to the arithmetic mean (which is simply the average of all investment returns), then the greater the standard deviation. Geometric mean considers compounding of annual returns, as compared to arithmetic mean, which is a simple average. The other 2 choices are not tested.

Which of the following stocks would be considered cyclical?

automobile manufacturer The performance of cyclical stocks follows the business cycle. In times of GDP expansion, they do well; in times of recession, they do poorly. The classic cyclical stocks are home building, automobile manufacturers and durable goods producers. All of these purchases are deferrable in hard times. Pharmaceutical companies are defensive and are not affected by the business cycle; in good times or bad, people must take prescribed drugs. Gold mining stocks are counter-cyclical. In bad economic times, people "flee to safety" and buy gold stocks. Computer software companies are growth companies.

An analyst evaluates a company's market prospects, sales growth, product line, profitability, cash flow, capital structure, price/earnings ratio and dividend yield and then compares these to other companies that are in the same economic sector to decide which company is the superior investment. This is an example of:

bottom up investment approach A "bottom up" investment approach focuses on the prospects of an individual company as compared to other companies in that sector. A "top down" investment approach looks at the prospects for various investment sectors to find those that will outperform the market and then "drills down" to find the specific stocks in that sector that are likely to be superior performers.

The semi-strong version of the efficient market hypothesis states that:

current securities prices reflect all publicly available information Efficient market theory is an academic approach to securities pricing in the market that states that securities prices instantaneously and fully reflect all available information. There are 3 versions of this theory: Weak Form: States that historical patterns in stock prices are of no use in predicting future price movements. The use of technical analysis to create "trendlines" is therefore, useless. This version is not widely accepted. Semi-Strong Form: States that current securities prices reflect all publicly available information. Thus, the value of securities in the market reflects publicly distributed information, but does not reflect information known by "insiders." This is the most widely accepted version. Strong Form: States that current securities prices reflect all information, whether publicly available or not. Thus, information known by "insiders" that has not been publicly disseminated, is already reflected in a security's price. This version is also not widely accepted.

A company's current assets double. Its current liabilities quadruple. The company's current ratio will:

decrease by 50% Assume that a company has $1 of current assets and $1 of current liabilities. The current ratio is $1 current assets / $1 current liabilities = 1. If the current assets double, they will now be $2. If the company's current liabilities quadruple, they will now be $4. The current ratio is $2 current assets / $4 current liabilities = .50. The current ratio has fallen from 1 to .50, a decline of 50%.

CAPM is used to calculate the:

expected rate of return CAPM (the Capital Asset Pricing Model) is used to identify the most "efficient" investments - meaning those that give the greatest return for the risk assumed. As long as the investment meets the minimum return dictated by the model, then it should be included in the portfolio. CAPM finds the "expected return of an investment" using the formula: Expected Return of An Investment = Risk-Free Rate of Return + Risk Premium*(*Risk Premium is: Beta x (the excess of the Expected Market Return over the Risk-Free Rate of Return) In the formula, Beta is the measure of risk. Thus, high Beta stocks must give a higher rate of return to meet the formula's investment threshold.

If the reader of corporation's financial statements wishes to get additional detail on items presented, this can be found in the:

footnotes The footnotes to a company's financial statements details the company's accounting policies (for example, when revenue is "booked," how inventories are valued) and give additional supporting detail that adds "color" to the numbers presented in the income statement and balance sheet. For example, the balance sheet might show "capitalized leases" as a simple number in liabilities, but the footnotes will give the year-by-year upcoming lease payment obligations.

A value fund manager has decided that her position in ABCD stock should be liquidated. This decision to liquidate was determined by the manager using:

fundamental analysis Fundamental analysis is used to decide which stocks to buy or sell, based on "fundamental" factors such as earnings, dividends, products, etc. Once that decision is made, it is always best to buy when the price is low or sell when the price is high. Technical analysis uses stock price chart patterns to identify a market "top" or a market "bottom." Once the sell decision is made, it would be best to wait for a market "top" to sell at the highest price possible. Review

The rate of return that considers compounding of returns of the time horizon of an investment is:

geometric rate of return Geometric rate of return is the compound annual rate of return produced by an investment. For example, a 3 year investment that returns +20% in the first year; -10% in the second year; and +20% in the third year has an arithmetic mean return of 10% (+20-10+20 = 30/3 = 10%) However, in this example, $1 invested will equal $1.20 after year 1 (+20%); $1.08 after year 2 (-10%); and $1.296 after year 3 (+20%). This is the same as a compound annual return of 9% and this is the geometric rate of return.

A customer buys a new issue inflation-adjusted government bond with a 4% coupon at par. After the first year, the inflation rate as measured by the CPI has increased by 5%. After the second year, the inflation rate increases by 8%. For the third year of holding the security, the customer will receive:

interest of $45.36 TIPS (Treasury Inflation Protection Securities) are issued with a fixed coupon that does not change. In Year 1, this bond will pay 4% of $1,000 par = $40. At the end of year 1, because inflation was 5%, the principal amount of the bond is adjusted to 1.05 x $1,000 = $1,050. In Year 2, the bond will pay 4% of $1,050 = $42 of interest. At the end of year 2, because inflation was 8%, the principal amount is adjusted to 1.08 x $1,050 = $1,134. In Year 3, the bond will pay 4% of $1,134 = $45.36 of interest

Growth companies are characterized by:

low dividend payout ratios and high price / earnings ratios Growth companies are characterized by high price-earnings ratios and low dividend payout ratios. Mature companies are characterized by low price-earnings ratios and high dividend payout ratios.

The dividend discount model can be used to value:

mature companies The Dividend Discount Model is a way of finding the theoretical price of common stock. It takes the anticipated future dividends to be paid by the company and discounts them to present value. Instead of having to discount each year's anticipated dividend payment, the formula can be reduced to one similar to that for a perpetuity. The reduced formula is: Expected Next Year Dividend Rate / Required Rate of Return for Equity Investors - Dividend Growth Rate For example, assume a company is expected to pay a $1 dividend next year. If the required rate of return is 8% and the expected dividend growth rate is 3%, then the projected price of the common stock is $1 Dividend / 8% - 3% = $1/.05 = $20. This model only works for companies that are in a "steady state" - so they are mature companies that are paying dividends at a rate that has been growing consistently. The model would not work for growth companies that do not pay dividends.

An investment generates the following annual returns: Year 1: 8% Year 2: 8% Year 3: 10% Year 4: 12% Year 5: 14% The return of 8% is the:

mode Given a sequence of returns, the mode is the number that occurs most often. Since 8% occurs twice, while the other 3 returns only occur once, 8% is the mode. The "median" is the centerpoint return. If the returns are arranged in ascending order, they are: 8%, 8%, 10%, 12% and 14%. The centerpoint number is 10% - the median. The mean is the arithmetic average return - in this case it is 8 + 8 + 10 + 12 + 14 = 52 / 5 years = 10.40%. Since the returns varied anywhere from 8 to 14%, the range is 6%.

A stock that moves at the same rate, but in the opposite direction, to the market, is one with a:

negative beta A stock that moves in the opposite direction to the market has a "negative" beta. Gold stocks are negative beta stocks. When the market is rising, people sell gold (prices fall) and buy stocks (prices rise). When the market is falling, people sell stocks (prices fall) and buy gold (prices rise) for safety.

If current liabilities of a company are subtracted from current assets of a company, the result is the company's:

net working capital The formula is current assets - current liabilities. (Total assets minus total liabilities equals net worth.)

A fully diversified portfolio eliminates:

non-systematic risk Non-systematic risk in a portfolio is the risk that can be diversified away. A fully diversified portfolio's price movements will mirror those of the market as a whole. Such a portfolio has a "beta" of 1.00. This portfolio has market risk only, also called "systematic" risk. This is the risk that cannot be diversified away (but one can hedge against a market downturn by buying puts). The portion of a portfolio "beta" that is more than 1.00 is the non-systematic risk component. This is inherent in a portfolio that is not fully diversified. Such a portfolio will rise faster than the overall market during market upswings; and will fall faster than the overall market during market downswings.

Monte Carlo simulation is used to assess a portfolio's:

probability of achieving investment returns under varying conditions Monte Carlo simulation is a computer-driven "decision-tree" analysis of possible portfolio returns that can be achieved based on varying factors, such as differing future interest rate levels; equity return levels; inflation rate levels, etc. It assesses the probability of getting the desired portfolio return over a long time horizon, during which these variables can change thousands of times.

The investment approach that analyzes the entire economic outlook to sort out the areas for higher growth potential, prior to deciding the specific investments to be made, is known as the:

top down approach A portfolio manager that uses a "top down" approach would look at the overall economy to identify those sectors that appear to have the best growth potential; and then would emphasize investments in that sector.

The P/E ratio of a stock measures:

valuation The P/E ratio is the Price to Earnings Ratio. It measures the stock's price relative to its earnings per share. A high P/E ratio means that the market is giving the stock a high valuation; a low P/E ratio means that the market is giving the stock a low valuation.

Standard deviation measures the:

variability of investment returns Standard deviation measures the variability of returns provided by an investment. It does not measure the level of investment return; nor does it measure the growth in investment return.