Suitability

Know Your Customer Rule

- financial means - fiscal responsibility - investment objective

Tactical Asset Allocation

- more flexible than strategic asset allocation - percentage in each asset class can change to take advantage of specific investment opportunities - Often used to determine the best time to change the asset allocation mix

Asset Allocation Strategy

1. Selecting the asset classes for portfolio 2. Setting target percentage for each asset class 3. Allowing for flexibility to adjust percentages 4. Choosing the specific securities - active asset management: growth, value, momentum - passive asset management: index funds or ETFs Rebalancing is periodically necessary with both management styles

Age-based asset Allocation Model

100% - your age = % invested in equities; remainder in bonds - rebalancing might occur on your birthday - as one gets older and the percentage changes, more money is shifted into bonds

A customer, age 40, is concerned that the inflation rate is ready to explode, and wishes to invest funds to protect against the consequences of such an event. The BEST asset allocation mix to recommend to this customer is:

100% money market instruments

The time horizon to be used when constructing a portfolio to pay for college expenses for a person who is expected to start college in 10 years and finish college in 15 years is:

15 years If a portfolio is being constructed to fund a person's college education, it must be able to provide income to pay for college until schooling is finished.

A customer is in the highest tax bracket and will possibly be subject to the AMT. Which of the following is the BEST investment recommendation? A 5.40% Municipal bond that is not subject to the AMT B 5.60% Municipal bond that is subject to the AMT C 6.00% Treasury bond with a long expiration D 6.00% Corporate bond mutual fund

A 5.40% Municipal bond that is not subject to the AMT Since this customer is in the highest Federal tax bracket (currently 37%), 37% of the return offered by taxable Treasury Bonds or Corporate Bonds would go to tax, and only 63% of the 6% return (3.78%) offered by these would be kept after-tax. Thus, the 5.40% or 5.60% tax-free municipal bonds are the best choices. Since this customer is possibly subject to the AMT (Alternative Minimum Tax), which adds back "tax preferences" to reported income and taxes the adjusted-up figure at a flat 26-28%, buying the bond that is NOT subject to the AMT is the way to go!

Which bond recommendation would be the MOST safe for an individual who seeks income that is free from federal income tax? A AA-rated revenue bond that is escrowed to maturity B AAA-rated general obligation bond C AA rated certificate of participation D Double-barreled bond

A AA-rated revenue bond that is escrowed to maturity

An investor believes that interest rates will be flat or falling into the future; and that prices may deflate. The MOST appropriate investment is:

A Long term U.S. Government bonds

A customer has $20,000 to invest, but needs immediate access to the funds to pay a variety of bills that will arrive over the next 3 months. The BEST recommendation is for the customer to deposit the funds to a: A Money market checking account B Money market mutual fund C Money market instrument D Treasury Direct account

A Money market checking account

What is the BEST investment recommendation for an individual in a high tax bracket who is risk averse? A Municipal bonds B Direct participation programs C U.S. Government bonds D Sovereign government bonds

A Municipal bonds he income from municipal bonds is exempt from federal income tax, and historically, these have been very safe investments. Thus, municipal bonds are the best recommendation for this customer.

Which bond recommendation is most suitable for a customer who wishes to avoid credit risk? A Pre-refunded bond B G.O. bond C Revenue bond D AAA corporate bond

A Pre-refunded bond When a municipality pre-refunds its debt, it backs those bonds with escrowed U.S. Government and Agency securities, making the credit rating AAA. This is the safest bond of the choices offered, since it is backed by collateral. A General Obligation bond is backed by faith, credit and unlimited taxing power of a municipal issuer, so it is pretty safe as well - but it is not secured. A Revenue bond is backed by a pledge of revenues from an enterprise activity, and these are less safe than G.O. bonds. AAA rated Corporate bonds are also very safe, but if they are long term bonds, a lot can go wrong for a company over a long term time frame. Again, these are not as safe as a pre-refunded bond.

A customer has just received a $100,000 inheritance and wants to know what to do with the money until he decides how to use it. He thinks that he will make his decisions on what to do with the funds within 3 months. The BEST recommendation is for the customer to buy: A Treasury Bills B Treasury Notes C Investment Grade Preferred Stock D Long Term Certificates of Deposit

A Treasury Bills

Which type of account does NOT grow tax deferred? A UTMA Account B 529 Plan C Coverdell ESA D Health Savings Account

A UTMA Account There is no tax deduction for contributions to custodial accounts (either UGMA or UTMA accounts) and income is taxable each year. In contrast, while there is no tax deduction for contributions to 529 Plans or Coverdell ESAs, the earnings in these accounts grow tax-deferred and when a distribution is taken to pay for qualifying educational expenses, the distribution is tax-free. Health Savings Accounts (HSAs) allow an employee covered by a high-deductible corporate health insurance plan to make a deductible contribution to an HSA; earnings grow tax-deferred; and when distributions are taken to pay for qualifying health care expenses, they are tax-free.

A 60-year old customer has a 401(k) account with your firm that has $280,000, mainly invested in growth mutual funds. The customer has an elderly widowed aunt who has died, and her estate attorney has contacted him, notifying him that he has been left $100,000 as an inheritance. The customer is single and has an annual income of $100,000 per year. He wants to use the inheritance to buy a retirement home, which he expects to do in 7 years. Over this investment time horizon, the general expectation is that interest rates will rise. The best recommendation to the customer is to invest the $100,000 in: A money market instruments B 7-year Treasury Bonds C 7-year Treasury STRIPS D 30-year Treasury Bonds

A money market instruments

A customer owns 1,000 shares of XYZZ stock, purchased at $40 per share. The stock is now at $45, and the customer has become neutral on the stock, but believes that the stock still has good long term growth potential. The client asks her representative for a "conservative recommendation" that will give her a positive portfolio return. The client should be told to: A sell 10 XYZZ 45 Call Contracts B sell 10 XYZZ 45 Put Contracts C sell 1,000 shares of XYZZ and sell 10 XYZZ 45 Call Contracts D sell 1,000 shares of XYZZ and sell 10 XYZZ 45 Put Contracts

A sell 10 XYZZ 45 Call Contracts

A registered representative has managed the account of her client for over 10 years. The client recommends her mother to the registered representative as a potential client. Mom, age 65, has just moved out of her house into a smaller condominium, and has netted a $200,000 profit from doing this. The client tells the representative that her mother should invest conservatively. When the representative reaches out to the mother, she tells her that she is retired and that her current pension, plus social security that will be received in a few years, will give her more income than she needs. She wants to invest the $200,000 for growth, with the intention of leaving that money to her grandchildren when she dies. What would be the best recommendation?

Aggressive growth fund

A married couple, ages 55 and 52, with no children, are both employed at DEF Corporation. They have asked for an evaluation of their current portfolio. They have a combined annual income of $200,000 per year and a fully paid home worth $500,000. Their current portfolio shows: $50,000Common Stock of DEF Corp in a 401K account $100,000Large Cap Growth Fund $150,000Government Bond Fund $150,000Corporate Bond Fund $200,000Money Market Fund Both intend to retire in 20 years and are conservative investors, looking for moderate growth and moderate risk. Which of the following recommendations is BEST for this couple? A The current portfolio allocation is consistent with their stated investment objective and risk-tolerance level B The portfolio should be reallocated based on their stated investment objective, reducing the cash and bond percentage by 50% and using the proceeds to buy a small or mid-cap growth mutual fund C The portfolio is overweighted in fixed income securities, which should be completely liquidated and the proceeds used to buy aggressive growth stocks D The current portfolio allocation overexposes the couple to stock-specific risk if the fortunes of DEF Corp. decline in the future

B The portfolio should be reallocated based on their stated investment objective, reducing the cash and bond percentage by 50% and using the proceeds to buy a small or mid-cap growth mutual fund

A 70-year old client wants to invest in U.S. Treasury securities. When performing the suitability determination, the client informs the registered representative that he is looking for after-tax income, liquidity, and to avoid market risk. The registered representative should be LEAST concerned with the: A client's tax bracket B client's age C coupon of recommended Treasury securities D maturity of recommended Treasury securities

B client's age Since Treasury securities are the safest security, they are an appropriate recommendation for a 70-year old client. So age really is not a concern with this recommendation. The client's tax bracket is a concern because the income is Federally taxable. If the client is in the highest tax bracket, maybe municipal bonds would be a better recommendation. The coupon of the recommended Treasury securities is important because this client wants income. Regarding the maturity of the recommended Treasury securities, the recommendation of a 30-year bond as opposed to a shorter-term investment could subject the customer to a high level of market risk (loss of market value if interest rates rise). This is another concern, since the customer wants to avoid market risk.

A new client has been employed as a manager at XYZ Corporation (NYSE listed) for the last 20 years and has a defined contribution pension plan at his employer that he has chosen to invest 100% in XYZ Common stock. The value of the pension plan is now $750,000. The customer is 7 years from retirement and has asked for advice about what steps he should take regarding his retirement account. As the adviser to the customer, your IMMEDIATE concern should be the:

B fact that the customer is concentrated in one stock and lacks diversification in his portfolio

A 50-year old customer is in a very low tax bracket. She lives in a state that has one of the highest income tax rates. The customer is seeking income and preservation of capital. She has a 10 year investment time horizon. The best recommendation would be a 10 year maturity: A Treasury Bond B investment grade corporate bond C investment grade municipal bond D Treasury STRIPS

B investment grade corporate bond Remember that interest rates are highest for corporate bonds because the interest income is taxable at both the federal and state level. Because this customer is in a low tax bracket, most of this return will be kept after tax - the customer will have the highest after-tax return with the corporate bond investment. As a general rule, customers in low tax brackets should invest in fully taxable bonds (corporates); while customers in very high tax bracket should invest in tax-free municipal bonds.

A retired married customer, age 73, has a portfolio that is invested in Blue Chip stocks and Treasury bonds that provides current income. The customer is concerned that he is paying a very high Federal and State combined income tax rate. An appropriate recommendation for this customer would be to diversify part of his portfolio into an investment in:

B municipal bonds This customer is concerned about paying a high Federal income tax rate and a high State income tax rate. By purchasing municipal bonds of his State of residence, the income from those bonds would be free of Federal, State and Local income taxes. This customer is too old to be able to contribute to tax-qualified retirement plans (the cut-off is age 72), making Choice A incorrect. Note that the customer could buy a non-tax qualified annuity, but the income from the annuity would be taxable anyway. The income from securities held in offshore accounts must still be reported on the customer's U.S. tax return and taxes paid in the U.S. on that income. Finally, the income from promissory notes is fully taxable at the Federal and State levels.

A constant dollar investment plan requires: A that the same dollar amount be invested periodically in new equities purchases B that the same aggregate dollar amount be kept invested in equities C the constant reinvestment of all dividends and interest received in the same securities D that a constant dollar amount be invested in U.S. securities

B that the same aggregate dollar amount be kept invested in equities

An individual who is 25 years from retirement has $500,000 to invest today. He is risk tolerant and is looking to withdraw $80,000 per year once he retires. Which asset allocation is BEST for this client? A 25% Stocks / 25% Bonds / 25% REITs / 25% Money Markets B 50% Stocks / 40% Bonds/ 10% Cash C 100% Bonds D 100% Stocks

B 50% Stocks / 40% Bonds/ 10% Cash

A 60-year old man is looking to create a portfolio that will provide current income and preservation of capital. Which of the following portfolios would be the BEST recommendation to the client? A Long term corporate bonds rated AA or better, high yield corporate bonds and blue chip stocks B Treasury bills, a money market mutual fund and bank certificates of deposit C Treasury STRIPS, corporate income bonds and PO tranches D Growth stocks, defensive stocks and foreign stocks

B Treasury bills, a money market mutual fund and bank certificates of deposit This customer wants current income and preservation of capital. Choice A provides current income, but does not provide preservation of capital. Long term bonds are subject to loss of value if interest rates rise; high yield corporate bonds have this risk as well as higher default risk; and blue chip stocks also can lose substantial value in a bear market. Choice B meets both objectives. Treasury bills, money market funds and bank certificates of deposit all provide income (but not high levels of income) and safety of principal. Choice C consists of long term securities that do not provide income, and that also have high levels of interest rate risk. Treasury STRIPS are zero coupon Treasury obligations - they have high levels of interest rate risk and do not provide current income. Corporate income bonds only pay interest if the corporation has enough earnings. PO tranches are CMO tranches that pay "Principal Only." Because mortgage payments in the early years are mostly interest and in the later years are mostly principal, they pay very little in the early years and make most of their payments in their later years. Thus, they are most similar to a long-term zero coupon bond with high levels of interest rate risk. Choice D consists only of common stocks, which do not provide for preservation of capital.

Bond Portfolio Construction

Bullet Strategy - set a target date for the bond maturities - buy bonds over time, all maturing on the target date - beneficial if interest rates rise, negative if interest rates fall Barbell Strategy - buying very short-term bonds and very long-term bonds with an average life near the investors target date - gains and losses on the bonds at the two ends of the barbell will vary as interest rates rise and fall Ladder Strategy (aka laddering) - buy a group of bonds at one time with maturities at regular intervals toward the customers target date - protects the portfolio in a rising interest rate environment

ABC stock is currently trading at an all-time high price of $150 per share. Your client contacts you about the stock, stating that he believes that the stock is ripe for a sell off after its next quarterly news announcement. He has $10,000 to use for a trade, but does not want to lose more than this amount. The BEST recommendation to the client is to:

Buy ABC Puts The key piece of information in this question is that the client does not want to lose more than his investment. If puts are purchased to speculate on a market price decline, the customer can only lose the premium paid if the market rises. If the customer shorts stock, there is unlimited loss potential in a rising market. If the customer sells calls, there is unlimited loss potential in a rising market.

What portfolio construction is most appropriate for a retired married couple, ages 60 and 70, for the wife and husband respectively? A 100% common stocks B 70% common stock/30% bonds C 35% common stock/65% bonds D 100% bonds

C 35% common stock/65% bonds

A 60-year old retiree is in a very low tax bracket. He has a low risk tolerance and wishes to make an investment that will provide income. Which is the BEST recommendation? A Mid-cap common stock B Municipal bond C Bank CD D Treasure STRIPS

C Bank CD Thus, we are left with bank certificates of deposit as the only viable choice. They are low risk and will provide income with a higher "after-tax" return for a person in a low tax bracket than equivalent maturity municipal investments. Treasury STRIPS are zero-coupon Treasury securities - they are safe, but they do not provide annual income.

Which of the diversification factors below will not reduce the non-systematic (credit) risk of a bond portfolio? A Maturity B Industry in which issuer operates C Coupon rate D Geographic location of issuer

C Coupon rate The coupon rate has no bearing on diversification to reduce potential credit risk. In the trading market, the price of a bond is determined by the market yield for that type of security - not the coupon rate. To reduce non-systematic risk (meaning the risk that any one security may be a "bad" investment), diversification of a bond portfolio by choosing different issuers, different industries, different geographic issuer locations, and different maturities (since long term bonds give issuers longer time periods in which they can go broke) are all valid

A customer calls her registered representative and says the following: "I'm looking for a safe investment for $100,000 that I have, that will give me a moderate level of income. I have 2 children, ages 12 and 13, and I will need to use these monies to pay for their college education, starting in 5 years." All of the following recommendations would be suitable EXCEPT: A Treasury bond mutual fund B Treasury bonds with 5, 6, 7, 8, and 9 year maturities C GNMA pass-through certificates with 5, 6, 7, 8, and 9 year maturities D FNMA debentures with 5, 6, 7, 8, and 9 year maturities

C GNMA pass-through certificates with 5, 6, 7, 8, and 9 year maturities GNMA pass-through certificates represent an ownership interest in a pool of underlying mortgages. Each month, the mortgage payments made into the pool are "passed through" to the certificate holders. If interest rates drop, then the homeowners in the pool will refinance their mortgages and prepay their old higher rate mortgages. These prepayments are passed through to the certificate holders, who are paid off much earlier than expected. If these payments are reinvested, since interest rates have fallen, the overall rate of return falls, and the anticipated monies needed to fund the college education will not be available. Prepayment risk does not exist with conventional debt securities.

Which of the following is NOT a suitable investment for Individual Retirement Accounts? A U.S. Government bonds B Corporate bonds C Municipal bonds D Zero coupon bonds

C Municipal bonds Municipal bonds are not suitable for tax deferred accounts such as pension plans and IRAs. These accounts are already tax deferred, so putting taxable investments in them that generate a higher rate of return than municipals is appropriate. Furthermore, these higher returns will compound tax deferred as long as they are held in the pension account. Municipals give a lower rate of return than governments or corporates because of the federal tax exemption on their interest income. They are a bad choice for retirement accounts. Finally, zero-coupon governments and corporates give a higher rate of return than municipals, since the annual accretion of the discount on these is taxable; and they are great investments to put in a retirement account; since then the annual accretion of the discount will build tax-deferred.

A value investor would consider all of the following EXCEPT a company's: A Price / Earnings ratio B Price / Book Value ratio C Stock price growth rate D Market share

C Stock price growth rate Value investors invest in undervalued companies - as measured by low Price/Earnings ratios and low Price/Book Value ratios - that have good market prospects. Thus, they also consider product line, market share, management, etc. Growth investors select investments based simply on growth in earnings or growth in market price; on the assumption that these will always be the best performing investments.

A young couple in a low tax bracket wishes to invest long term for their infant child's college education. They are looking for a safe investment that requires little involvement on their part until the child reaches college age. The BEST recommendation would be: A T-Bills B T-Notes C T-Strips D T-Bonds

C T-Strips These are long term zero coupon bonds that can be purchased at a deep discount and then grow internally until they mature at par, years in the future. These would be purchased with maturity dates that match the years the kids would be in college. There are no semi-annual interest payments to reinvest, which would be the case if conventional T-Bonds were purchased, so T-Strips meet the customer's wish for little involvement.

A 65-year old man is retired and living on social security. He is married and his wife does not work. The client has inherited a small amount of money that he wishes to invest. What should you recommend as an investment? A Individual securities B Variable annuities C CDs D Bond funds

CDs It would be nice to have more information, such as the customer's investment objective and risk tolerance, but that is not given. Since this is a retired individual living on social security, he really does not have investment funds that can be put into risky assets. The safest asset given is CDs, which would provide extra income and safety of principal. You might argue that a bond fund could be recommended, but the NAV of a bond fund will decline in a rising interest rate environment, so there is the risk of loss of principal. This is not the case with a CD.

Asset Allocation

Classic Models 1. Constant-Ratio 2. Constant-Dollar - maintain fixed percentages in stocks and bonds - portfolio rebalanced periodically to return to the original percentages

A client with young children wants to invest $1,500 a year to pay for their ongoing educational expenses. Which recommendation would give the customer tax-free growth and tax-free distributions if these distributions are used to pay for educational expenses? A Coverdell ESA B 529 Plan C 457 Plan D UGMA Account

Coverdell ESA The maximum annual contribution to a Coverdell ESA is $2,000 per year per child, so this fits the customer's $1,500 per year contribution amount. Coverdell ESA contributions grow tax-deferred and are tax-free as long as they are used to pay for qualified educational expenses - which includes all school levels (grade school, secondary school, post-secondary school, etc.). A 529 Plan allows for much bigger contribution amounts and could only be used for college - until the 2018 tax law changes! Now that up to $10,000 per year can be taken from a 529 Plan to pay for lower level education expenses, the 529 Plan would be a correct answer as well. So if you see a similar question on the exam, it probably has not been updated, and to get the point, choose Coverdell ESA - and also complain at the test center so they clean up the question! Income in UGMA (Custodial) accounts is taxable annually, so they do not fit the customer's needs. Finally, 457 Plans are retirement plans, not education savings plans. Also note that the question does not address the fact that a Coverdell is not available to high-earning individuals.

When making a recommendation of corporate commercial paper to a customer, which risk is the MOST important consideration?

Credit risk

Customers A, B, C and D have their portfolio assets allocated as follows: A B C D Money Markets 15%5%5%0% Treasury Bonds 40%10%20%20% Speculative Bonds 10%30%10%30% Blue Chip Equities 15%15%20%10% Small Cap. Equities 10%10%30%5% Emerging Markets 10%20%10%30% REITs 0%10%5%5% Which asset allocation is MOST appropriate for a risk-intolerant older customer with a short investment time horizon?

Customer A For an older, risk-intolerant customer, safe fixed income securities are the best recommendation. Customer A's portfolio has the highest allocation of safe Treasury Bonds, which have the highest credit rating and give an assured income stream.

All of the following are bond portfolio construction methods designed to reduce interest rate risk EXCEPT: A Ladder B Bullet C Barbell D Balloon

D Balloon

A 65-year old widow that is in a low tax bracket and that has a low risk tolerance wishes to make an investment that will provide income. Which is the BEST recommendation? A Growth mutual fund B Emerging markets mutual fund C Long term municipal bond fund D Bank certificates of deposit

D Bank certificates of deposit They are low risk and will provide income with a higher "after-tax" return for a person in a low tax bracket than equivalent maturity municipal investments. Growth stocks and emerging markets stocks do not provide income; rather, they provide capital gains.

When recommending domestic corporate long-term debt instruments to a customer, which of the following risks is the LEAST important consideration? A Inflation (purchasing power) risk B Market risk C Credit risk D Currency exchange risk

D Currency exchange risk

Which bond recommendation would be the LEAST safe for an individual who seeks income that is free from federal income tax? A AA-rated revenue bond that is escrowed to maturity B AAA-rated general obligation bond C PHA bond D Double-barreled bond

D Double-barreled bond This one is special! A bond that is escrowed to maturity (ETM) is backed by escrowed U.S. Government securities - so it becomes the "safest" municipal bond because it becomes government backed. A PHA bond is a Public Housing Authority revenue bond - this is backed by the rental income from subsidized housing, and also backed by the full faith and credit of the U.S. Government to make it marketable. Again, this is another "safest" municipal bond because it is government backed. AAA rated general obligation bonds are extremely safe - they are backed by unlimited tax collections and have a top credit rating. Finally, a double-barreled bond is a revenue bond that is additionally backed by a municipality's "full faith and credit" if the revenues fall short, so it has a back-up G.O. backing. It is also extremely safe - just not as safe as the other choices. Note that this choice does not have a credit rating as a guide - if it did, it would be much easier to answer this question!

A wealthy, sophisticated investor with a high risk tolerance has just turned extremely bullish on the market. To profit from this, the BEST recommendation to the client would be to: A buy index calls B buy index puts C buy inverse ETFs D buy leveraged ETFs

D buy leveraged ETFs

A young couple in a low tax bracket have 2 young children and they want to start saving for the kids' college education. The BEST recommendation would be: A T-Bills B Growth funds C Municipal bond funds D 20 year maturity municipal bonds

Growth funds Because the couple is in a low tax bracket, tax-free municipals are not appropriate. They are only suitable for customers in high tax brackets. So we are left with the choice of either T-Bills or Growth funds. T-Bills are safe, but give a very low return. Growth funds over the long term until the kids go to college are the best choice offered.

growth investing

Growth investors select stocks based on growth in sales, earnings, or share price. Growth investors believe that high growth rates in sales, earnings, and share price predict that this trend will continue in the future.

Asset Class Risk Pyramid

High Risk to Low risk 1. Derivatives 2. Options 3. Small-Cap Stock 4. Mid-Cap Stock 5. Blue-chip stock 6. Preferred Stock 7. Corporate Bonds and Notes 8. Municipal Bonds and Notes 9. U.S. Government Bonds and Notes 10. Cash & Money Market Securities

A customer has a $1,000,000 portfolio that is invested in the following: $250,000Large Cap Growth Stocks $250,000Large Cap Defensive Stocks $250,000U.S. Government Bonds $250,000Investment Grade Corporate Bonds During a period of economic expansion, the securities which will enjoy the greatest price appreciation are likely to be the: I Large Cap Growth Stocks II Large Cap Defensive Stocks III U.S. Government Bonds IV Investment Grade Corporate Bonds

I Large Cap Growth Stocks IV Investment Grade Corporate Bonds

A Registered Investment Adviser has a retired client who wishes to put aside funds for the purchase of a car 5 years from now. Preservation of capital is important to this client. The RIA should recommend investments in: I Money market funds II Bank certificates of deposit III 5 Year Treasury Bonds IV 30 Year Treasury STRIPS

I Money market funds II Bank certificates of deposit III 5 Year Treasury Bonds

Customer Name:Jane DoeAge:41Marital Status:MarriedDependents:1 Child, Age 13Occupation:HomemakerHousehold Income:$140,000Net Worth:$240,000 (excluding residence) Own Home: Yes Investment Objectives: Total Return / Tax Advantaged Investment Experience:12 years Current Portfolio Composition: 8% Common Stocks 62% Corporate Bonds 30% Money Market Fund In order to make an appropriate recommendation to this customer, the registered representative should be concerned about the customer's:

I investment time horizon, with specific emphasis on whether the 13 year old child will go to college and how this expense will be funded II strategic asset allocation needs with specific emphasis on the fact that the customer's portfolio mix might be overly conservative for a person that is only 41 years old III retirement needs, with specific emphasis on whether the customer's spouse is covered by a pension plan or if the customer must fund her retirement on her own IV life insurance coverage, with specific emphasis on the fact that this non-working wife and child must be supported if the husband dies

A customer has the following investment mix: 25%Growth Stocks 25%Defensive Stocks 25%Investment Grade Corporate Bonds 25%Speculative Stocks During a period of economic recession, the best performing asset classes are likely to be: I Growth Stocks II Defensive Stocks III Investment Grade Corporate Bonds IV Speculative Stocks

II Defensive Stocks III Investment Grade Corporate Bonds

Which statements are TRUE about asset classes and investment time horizons?

II Interest bearing investments are the better choice for short term time horizons III Equity investments are the better choice for long term time horizons Equity investments typically produce a higher rate of return with higher volatility - thus a long time horizon is needed to achieve consistent results with equity investments. Interest bearing investments produce a lower rate of return with lower volatility - thus they are suitable for portfolios with short time horizons.

A customer has a $1,000,000 portfolio that is invested in the following: $250,000Large Cap Growth Stocks $250,000Large Cap Defensive Stocks $250,000U.S. Government Bonds $250,000Investment Grade Corporate Bonds During a period of economic recession, the securities which will depreciate the least are likely to be the: I Large Cap Growth Stocks II Large Cap Defensive Stocks III U.S. Government Bonds IV Investment Grade Corporate Bonds

II Large Cap Defensive Stocks III U.S. Government Bonds

Which statements are TRUE regarding the account of a customer who has an investment objective of making short term trading profits from investments in equity securities?

II Such a strategy will cause the customer to be subject to a higher level of market risk as compared to a "buy and hold" strategy maintained over a long term time frame IV Such a strategy will have less favorable tax consequences as compared to a "buy and hold" strategy maintained over a long term time frame

An elderly customer seeking extra income who has $100,000 to invest could be recommended which of the following?

II The $100,000 purchase of dividend paying blue chip stocks in a cash account against which calls are sold IV The $100,000 purchase of Treasury bonds The purchase of a variable annuity is not suitable for an elderly customer. The whole concept behind a variable annuity is that the product has time to build value on a tax deferred basis in the separate account prior to annuitization. An elderly customer needs the income now. Covered call writing is the most popular retail income strategy in a flat market, and is appropriate for conservative investors that are looking for extra income. The customer sells calls against stock that is already owned, getting premium income. This would be suitable. The margining of blue chip stock positions to "double up" on the amount of stock owned (since Regulation T margin is 50%) is not suitable because this does not come for free! The customer is borrowing the extra money to buy the new shareholding, using his existing stock as collateral, and he must pay interest on the loan. The interest charge will eat up any dividends that the stocks pay - so there goes his income. The purchase of Treasury bonds is suitable, since they provide current income and they are safe as it gets.

Which statements are TRUE about defensive stocks that are included in a portfolio allocation model? Defensive stocks have:

II lower expected returns than other equities included in the portfolio IV lower standard deviations (risk) than other equities included in the portfolio Defensive stocks are minimally affected by the business cycle, with classic defensive stocks being food and pharmaceuticals (in bad times, people must still eat, and must still take prescription drugs for their illnesses or suffer the consequences!) Because their earnings stream is so stable, defensive stocks have lower risk (as measured by variability of returns - AKA standard deviation) than other equity securities. Because of their lower risk, their returns are correspondingly lower as well.

Rebalancing

If one asset class greatly outperforms another asset class in an asset allocation model, the portfolio must be rebalanced. Part of the overperforming class must be liquidated, so its dollar value returns to the strategically set percentage; with the proceeds invested in the underperforming class. In this manner, the portfolio is rebalanced to the strategically set optimal percentages.

Since this customer is in the highest Federal tax bracket (currently 37%), 37% of the return offered by taxable Treasury Bonds or Corporate Bonds would go to tax, and only 63% of the 6% return (3.78%) offered by these would be kept after-tax. Thus, the 5.40% or 5.60% tax-free municipal bonds are the best choices. Since this customer is possibly subject to the AMT (Alternative Minimum Tax), which adds back "tax preferences" to reported income and taxes the adjusted-up figure at a flat 26-28%, buying the bond that is NOT subject to the AMT is the way to go!

Income bond An income bond is a corporate bond that only pays interest if the corporation earns enough income - so this certainly does not meet the widow's requirement for income. Income mutual funds invest in a diversified portfolio of high interest paying bonds and high dividend paying stocks - this is suitable. U.S. Government bonds or funds holding these securities, provide both income and safety, and thus are suitable as well.

Portfolio Construction

Information that MUST be gathered by registered rep: - current financial status (assets and liabilities) - family composition (dependents) - tax status (tax bracket, low or high) - employment (longevity, future prospects or changes) Information that SHOULD be gathered by registered rep: - investment objectives - financial goals (retirement, children's education, etc.) - current financial needs (cash flow, future capital needs) - risk tolerance - investment time horizon - investment knowledge and experience (current strategies)

A customer who is retired wants to select an investment that is marketable, and that provides the highest rate of return. The BEST choice would be to recommend: A Treasury Bills B Treasury Notes C Investment Grade Preferred Stock D Certificates of Deposit

Investment Grade Preferred Stock

A couple wants to invest for the college education of their 4 children. The children are 1, 5, 10, and 16 years old. What is the biggest suitability concern when making an investment recommendation?

Investment time horizon The oldest child is 16 years old and will be entering college in 2 years. Any investment recommendation must take into account that liquidation of positions to pay for college must commence in 2 years. This is the investment time horizon that must be used for any recommendation. Liquidity is also a concern - any assets chosen as an investment must be able to be liquidated quickly when funds are needed in 2 years. However, first we must choose assets with a 2-year investment time horizon, and then second, these must be assets that can be liquidated easily (little liquidity risk).

Strategic Asset Allocation

Money allocated in fixed percentages among the asset classes in the risk pyramid Must consider customer's: - age - risk tolerance - desire for preservation of capital - time horizon

An IRA is allocated in large cap stocks, TIPS, foreign stocks and municipal bonds. When reviewing this portfolio, you should be MOST concerned about the:

Municipal bond holding Municipal bonds are not suitable for tax deferred accounts such as pension plans and IRAs. These accounts are already tax deferred, so putting taxable investments in them that generate a higher rate of return than municipals is appropriate. Furthermore, these higher returns will compound tax deferred as long as they are held in the pension account. Municipals give a lower rate of return than governments or corporates because of the federal tax exemption on their interest income. They are a bad choice for retirement accounts. TIPS (Treasury Inflation Protection Securities) are great for retirement accounts. Their return is adjusted each year by that year's inflation rate, and this builds tax deferred in a retirement account. Finally, good quality equities have historically given a higher total return than bond investments, so they are good for long term investment in a retirement plan.

A 68-year old new customer has investment objectives of preservation of capital and income in retirement. The customer has a low risk tolerance and is in the 35% marginal federal tax bracket and is in the 10% state tax bracket. Which investment recommendation would be most suitable for this client?

Pre-refunded general obligation bonds

A customer with additional funds to invest seeks income, but thinks his portfolio is too heavily weighted in debt securities. The BEST recommendation to the customer is: A Treasury securities B Municipal securities C Preferred stocks D Industrial development bonds

Preferred stocks

A customer, age 25, is looking to invest in securities with the objective of growth to protect against the effect of long term inflation on his portfolio's value. The customer believes that active asset management, along with its higher fees, is not worthwhile. Which recommendation is MOST suitable for this customer?

S&P 500 Index Fund This customer is looking for long term growth, so common equities are an appropriate investment rather than long term bonds. Since the customer does not believe in active asset management, a passive approach is best - that is, an index fund that has very low ongoing fees.

A smaller business with variable cash flow is looking to establish a pension plan for its 50 employees. It wants a plan that allows it to contribute the largest possible amount for its employees, but wants the flexibility to reduce contributions in lean years. The BEST recommendation is a:

SEP IRA

The setting of specific goals for an investment plan to be created for a customer is known as:

Strategic asset management Strategic asset management is the setting of the investment "strategy" under an asset allocation scheme.

A 60-year old customer desires an investment that will provide for retirement income when she reaches age 65. The customer is able to invest $1,000 per month over that time period. Which of the following recommendations is most suitable?

The purchase of a variable annuity contract A variable annuity contract places no dollar limit on contributions; and the income earned on investments is tax deferred during the accumulation period. Thus, the customer would be allowed to contribute $12,000 per year; and would receive the benefit of the tax deferred build up. At age 65, she could annuitize and convert the value of the account into an annuity contract that would make payments for her life. This is the best choice offered.

Value investing

The strategy of selecting stocks that trade for less than their intrinsic values. the selection of equity investments based on finding undervalued issues using fundamental analysis. Value investors select stocks that they believe are good values - that is, underpriced in the market. Undervalued stocks are identified by looking at Price/Earnings ratios, Price/Book Value ratios, etc. Value investors believe that the market will, ultimately, determine that these stocks were underpriced - so their prices should move up in the future.

A customer who is retired wants to select an investment that is liquid, marketable, and that provides regular income. The BEST choice would be to recommend: A Treasury Bills B Treasury Notes C Preferred Stock D Certificates of Deposit

Treasury Note Certificates of Deposit are non-negotiable - they are non-marketable, so this does not meet the client's needs. Preferred stock is marketable, but not as marketable as Treasury securities, making Treasury securities the better choice. So we are left with either a T-Bill or a T-Note. Treasury notes pay interest semi-annually; while Treasury Bills do not provide a regular income stream, so a T-Note is the better choice.

A new client who is in the lowest tax bracket has 2 young children. He has just inherited $10,000 and wants to use the money to invest for the college education of both children. The client has never invested before and states that he wants an investment with no risk. What recommendation is appropriate? A Municipal bonds B Treasury bills C Municipal bond fund D Blue chip stocks

Treasury bills The key wording here is that the customer wants "no risk." The only risk-free security offered as a choice is T-Bills. It could be argued that blue chip stocks would be a better choice to build a college education fund over a long-term time frame, but they are not risk free. Also note that municipal bonds are not appropriate because the customer is in the lowest tax bracket.

Defensive securities

a company whose business is not affected by the business cycle, thus the company does not have earnings variability due to changes in the economic cycle. Defensive stocks include pharmaceuticals, and soft drink and beer manufacturers.

A registered representative has a client who is an exceptionally intelligent doctor of medicine. The doctor does most of his own investment research and makes many of his own investment decisions. The doctor is married, but his wife is not involved in the investment planning or decision-making process. When constructing a portfolio for this client, the registered representative should:

balance the portfolio in a manner that addresses the doctor's investment strategy and that customizes the strategy to meet the needs of the spouse

A customer account holds the following: 10%Market Index-Linked CDs 20%Plain Vanilla CMOs 20%ACME Drug Company shares 10%REITs 25%Health Care Sector ETFs 15%Growth Fund Shares This portfolio is MOST susceptible to which risk?

business risk This portfolio is concentrated in the Health Care sector, with 25% of the portfolio being in Heath Care ETFs and 20% in a drug company. A portfolio concentrated in one stock or industry is susceptible to business risk - the risk that the business may turn sour. For drug companies, this can result from existing profitable drugs losing patent protection, so prices and profitability drops; class-action lawsuits for selling dangerous drugs, etc.

A 60-year old man who is living on social security payments inherits $250,000. He seeks an investment that gives growth and income. The BEST recommendation would be to:

buy stocks and bonds This customer seeks growth and income. A municipal bond fund gives income, but because this customer is in a low tax bracket, municipals are not suitable. This customer, living on social security, may not be sophisticated enough to sell calls against long stock positions (covered call writing). Furthermore, the sale of covered calls gives income, but it does not give growth. If the stock price appreciates, those shares will be called away. Treasury securities give safety and income; however zero-coupon bonds, while they appreciate based on the discount yield at which they are purchased, do not give "growth." Only equities give growth and bonds give income, so Choice D is the best one offered. This customer should be recommended a portfolio that consists of 60% bonds for income (the customer's age) and 40% stocks.

The time horizon to be used when constructing a portfolio for a person who will retire in a few years is the:

expected lifetime of that person If a portfolio is being constructed to fund a person's retirement in a number of years, it must be able to provide retirement income to that person for his or her lifetime. This is the appropriate time horizon.

An investment strategy where a higher price is paid for a stock based upon expected returns is:

growth investing

The customer has decided to purchase a home instead of renting. The price of the home is $750,000 and the customer intends to put down 20% and obtain a mortgage for the balance. The customer explains that he will need the $150,000 down payment in 30 days. The best recommendation to the customer is to liquidate his:

growth stocks and blue chip stocks immediately in the amount of $150,000 to obtain the necessary cash down payment

A customer, age 51, has a 20 year investment time horizon, a moderate risk tolerance, and is looking for investments that provide both income and growth. The best recommendation would be: A money market instruments B mutual funds C bonds D large capitalization growth stocks

large capitalization growth stocks Money market instruments are very safe, but provide little income and no growth. These would be recommended to a customer seeking preservation of capital - not to a customer seeking income and growth. Choice B, mutual funds, is too generic to be a valid choice. There are all kinds of mutual funds out there, for all types of investment objectives. Choice C, bonds, is also too generic to be a valid choice. Also, while bonds provide income, they do not provide growth. Choice D, large capitalization growth stocks, is the best one offered. Large capitalization stocks pay dividends for income, and also offer long term growth potential, meeting both of the customer's objectives.

Customer Jane Jennings' suitability information is presented below: Age:39 Marital Status:Single Dependents:1 Child - Age 10 Annual Income:$80,000 Tax Bracket:28% Net Worth:$510,000 excluding home Home:$350,000 fully paid Investment Portfolio:$422,000 (60% equities; 20% long bonds; 20% money market) The customer wants to start a college fund for her child. The anticipated tuition, starting 8 years from now, is $50,000 per year ($200,000 total tuition). Which of the following recommendations is most appropriate for this customer?

liquidate $160,000 of the common stock and invest the proceeds in laddered Treasury Notes and Bonds of $40,000 amounts maturing 8, 9, 10 and 11 years from now

Active portfolio management is:

managing a portfolio to exceed the performance of a benchmark portfolio Active portfolio management practitioners believe that they can outperform a benchmark portfolio (say an index fund) by finding undervalued securities in the marketplace. Passive portfolio managers, in contrast, believe that the market is "efficient" in pricing securities so that one cannot find "undervalued" securities. Passive portfolio managers simply buy index funds (which are managed to match the composition and performance of the chosen index).

Passive portfolio management is:

managing a portfolio to meet the performance of a benchmark portfolio Passive portfolio management is the management of a portfolio to meet the performance of a benchmark, such as a designated index. Active portfolio management attempts to beat the performance of the benchmark portfolio through better security selection and better investment timing.

Defensive stocks included in a portfolio's construction will minimize exposure to:

market risk Defensive stocks are unaffected by the business cycle, so their prices do not move as much (up or down) compared to the movements of the general market. Thus, these investments reduce market risk in a portfolio.

The couple plans to retire in the next year, sell their home and move to a retirement community where a new home will cost $190,000. They wish to supplement their retirement income, which will be approximately $40,000 from their retirement plan and $8,000 from Social Security. The best recommendation to the couple is to take the $300,000 net proceeds from the sale of the home after paying off its mortgage and:

pay for the $190,000 new home in full and invest the extra $110,000 in high yielding blue chip preferred stocks to provide retirement income

If one asset class greatly underperforms another class in an asset allocation plan, the portfolio must be:

rebalanced When investment performance varies over time from one asset class to another, the target percentage allocations will shift from their optimal setting. To bring the portfolio back to these targets, it must be rebalanced - that is, a portion of the overperforming class(es) must be sold off and the proceeds reinvested in the underperforming class(es).

A customer owns 1,000 shares of XYZZ stock, purchased at $40 per share. The stock is now at $45, and the customer has become extremely bearish on the company. The client asks her representative for an "aggressive recommendation." The client should be told to: A sell 10 XYZZ 45 Call Contracts B buy 10 XYZZ 45 Put Contracts C sell 1,000 shares of XYZZ and buy 10 XYZZ Put Contracts D sell 10 XYZZ 45 Put Contracts

sell 1,000 shares of XYZZ and buy 10 XYZZ Put Contracts

Customer Name: Jack and Jill Customer Ages: 62 and 57Marital Status: Married - 39 years Dependents: None Occupations : Jack - Manufacturing Manager - Dyno-Mite Corp. Jill - Marketing Consultant - Self Employed Household Income :$140,000 Joint Income($100,000 for Jack and $40,000 for Jill) Net Worth: $1,100,000 (excluding residence) Own Home: Yes $420,000 Value, No Mortgage Investment Objectives: Income / Tax Advantaged Risk Tolerance: Moderate Investment Time Horizon:25 years Investment Experience:30 years Tax Bracket:30% Current Portfolio Composition: Cash in Bank:$30,000 Growth Fund:$50,000 Variable Annuity:$50,000 Growth Stocks:$150,000Retirement Accounts: Jack's IRA:$100,000 invested in growth stocks Jack's 401(k):$600,000 invested in Dyno-Mite Corp. stock Jack's 529 Plan for Grandchild:$20,000 in growth mutual fund To meet the customer's investment objective of tax advantaged income, the BEST recommendation is for the customer to:

set a minimum and maximum threshold price to liquidate as much of the Dyno-Mite stock as the customer will permit, and invest the proceeds in high yielding common and preferred stocks

The target allocation for a specific asset class has been set at 20% of total assets under an asset allocation scheme. The manager is permitted to reduce this percentage to 15%; and can increase it to 25%; as he or she sees fit. If this action is taken by the manager, this is termed:

tactical asset management The selection of the percentage of total assets to be allocated to a given asset class is called "strategic asset management" - that is, setting the investment strategy. The permitted variation from this percentage that is given to the asset manager, so that the manager can take advantage of market opportunities, is called "tactical asset management".

Customers A, B, C and D have their portfolio assets allocated as follows: ABCD Money Markets15%5%5%0% Treasury Bonds40%10%20%20% Speculative Bonds10%30%10%30% Blue Chip Equities15%15%20%10% Small Cap. Equities10%10%30%5% Emerging Markets10%20%10%30% REITs0%10%5%5% Which customer's portfolio is MOST susceptible to a cyclical economic downturn?

timing risk Timing risk is the risk that trades will not be performed at the best market prices. Active traders are highly subject to this risk. Active traders will only trade securities in "deep" markets such as NYSE or NASDAQ common issues. They would not trade illiquid securities (e.g., OTC Pink Sheet issues) since they would incur "liquidity risk." Liquidity risk is the risk that a security can only be sold by incurring large transaction costs. Inflation (purchasing power) risk is the risk that inflation will reduce an investor's real returns. Active traders are not concerned with inflation risk because they hold their investments for very short time periods. Since active traders are trading common stocks, call risk is not a consideration (common stocks are non-callable).

The customer informs you that he just got married and that his wife intends to work for the next 5 years before they think about children. In order to make recommendations to the client due to these changed circumstances, the registered representative should:

update the account profile to include the wife's financial information

The investment strategy that involves paying a lower price for a security based on the expectation that the market is mispricing the issue is:

value investing Value investing is the selection of equity investments based on finding securities that are fundamentally undervalued in the marketplace. These tend to be solid companies that are currently "out of favor." Value investors look at such fundamental factors as the Price/Earnings ratio; and Price/Book Value ratio to find companies that are undervalued relative to their market sector.