Suitability: Portfolio Construction / Asset Allocation

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

A Coverdell ESA

A 30-year old single individual wishes to invest for retirement. He is employed at a high paying job at a stable employer, has a high risk tolerance and, has no current income needs from his investments. The BEST asset allocation to recommend to the customer is: A 50% common stocks / 50% bonds B 100% common stocks / 0% bonds C 0% common stocks / 100% bonds D 33% common stocks / 33% bonds / 33% cash

B 100% common stocks / 0% bonds This customer can assume risk, has no current income needs, and has a 40-50 year investment time horizon. The best answer is Choice B, since the customer should be weighted at least 70% in common stocks (100% minus one's age as a general guide). This is not offered as an answer, but because this individual has a "high risk" tolerance and a stable job, the equity allocation can be increased. Review

What portfolio construction is most appropriate for a retired doctor who is age 75? A 100% common stocks B 75% common stock / 25% bonds C 25% common stock / 75% bonds D 100% bonds

C 25% common stock / 75% bonds

Which of the following investments is LEAST liquid? A Mutual funds B Long term corporate bonds C Private placements D Closed-end funds

C Private placements

The risk that the amount invested may not fully be recovered.

Capital Risk/ Market Risk

The risk that the issuer cannot make interest and principal payments as due.

Credit Risk

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: A 5 years B 10 years C 12.5 years D 15 years

D 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.

Which statements are TRUE about speculative stocks that are included in a portfolio allocation model? Speculative stocks have: I higher expected returns than other securities included in the portfolio II lower expected returns than other securities included in the portfolio III higher standard deviations (risk) than other securities included in the portfolio IV lower standard deviations (risk) than other securities included in the portfolio

I and III

is the risk that rising market interest rates will force the prices of securities down. Fixed income securities will show the greatest declines in value, with longer term and lower coupon issues falling the greatest.

Interest Rate Risk

The risk that selling a position will result in higher than normal transaction costs (commissions). This is typical for smaller, thinly traded issues.

Liquidity Risk

The risk that buying and selling occur at disadvantageous price levels due to poor market timing.

Timing Risk

A 60-year old man, whose investment objectives are income and capital gains, wishes to buy securities that allow for liquidity during the trading day. The BEST recommendation would be: A ETFs B ETNs C UITs D Mutual Funds

A ETFs Both ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) trade, so they allow for liquidity during the trading day. There is no trading of mutual funds and UITs - these are redeemable securities. Mutual funds can be redeemed at NAV based that the close of the trading day; UITs are redeemable with the marketing agent, who will buy them at current NAV and remarket them to another investor for their remaining value. Therefore, we are down to the choice of an ETN or an ETF. This customer is looking for capital gains. This is possible with an ETF, because it holds a portfolio of equity securities that can grow in value over time. An ETN is a fixed income structured product that trades - fixed income securities are not designed to provide capital gains.

Which bond portfolio where all investment is made up front would be LEAST negatively affected by a sharp rise in interest rates? A Ladder B Bullet C Barbell D Balloon

A Ladder The idea behind a bond ladder is to spread bond maturities in a portfolio over fixed intervals, typically 10 maturities in intervals of 2 years each. A typical ladder might have 10 maturities ranging from 2 to 20 years, with an average maturity of around 10 years. Because of this broad diversification by maturity, a rise in interest rates will not impact the portfolio as negatively as compared to a bullet or barbell portfolio construction. If interest rates rise, the loss on the longer term bonds in the portfolio is offset by the fact that shorter term bonds are maturing soon and the proceeds can be reinvested at higher rates.

A customer in the highest tax bracket has $500,000 to invest. The customer is subject to the AMT. The BEST recommendation would be an investment grade: A Municipal bond yielding 2.50% that is not subject to the AMT B Municipal bond yielding 2.70% that is subject to the AMT C Treasury bond yielding 3.50% D Corporate bond yielding 3.75%

A Municipal bond yielding 2.50% that is not subject to the AMT Choice A yield after federal tax is paid - 2.50% (none of yield is taxed) AMT= Alternative Minimum Tax

The portfolio management technique that uses a market index as a performance benchmark that the asset manager must meet is called: A Passive asset management B Active asset management C Strategic asset management D Tactical asset management

A Passive asset management passive asset management is simply the management of a portfolio to match the benchmark return (the "passive return"). Active managers believe that underpriced securities can be found in the market and that performance of the benchmark can be exceeded. Passive managers believe that the market is efficient at pricing securities and that one cannot do any better than the "market" return as measured by a relevant index. Review

Establishing the structure of a portfolio to meet specific financial goals is called: A Strategic allocation B Tactical allocation C Rebalancing D Risk adjustment

A Strategic allocation

An investor has $50,000 that she wishes to invest for her child's college expenses, which the child starts next year. The most suitable recommendation to the client is to invest the funds in: A Treasury bills B Intermediate-term bonds maturing in 5 years C Long-term bonds of blue chip companies maturing in 10-30 years D a mutual fund based on the S&P 500 Index

A Treasury bills The client will need access to the funds in 1 year to start paying for college. The client cannot afford an investment loss, so the safest most liquid security listed as a choice is Treasury bills - which have a maximum 1-year maturity limiting interest rate risk and are government guaranteed, limiting credit risk.

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.

An investment strategy where a higher price is paid for a stock based upon expected returns is: A growth investing B value investing C conservative investing D passive investing

A growth investing A growth investor buys a stock based upon demonstrated growth in earnings or sales over time. The theory is that such companies can continue to grow rapidly, and therefore should command a higher market price.

An elderly investor has a short-term investment time horizon, is very concerned about loss of liquidity and is very risk averse. Your main concern when making a recommendation to this client is: A preservation of capital B safety of principal C growth of principal D tax benefit

A preservation of capital Preservation of capital is a concern for client who has no buffer if investment values decline. Such a client cannot afford to lose any money and should only be recommended CDs and money market funds as an investment. Because this client has " liquidity needs," he or she is in this situation.

Value investors: A seek to find investments that are undervalued by the market B determine the value of a security through fundamental analysis C invest in securities included in the Value Line Index D make their investment decision based upon the market performance of the security

A seek to find investments that are undervalued by the market Value investors believe that the market is not completely efficient at pricing securities and that undervalued securities can be found in the marketplace. Once the market realizes the true worth of these undervalued companies, their prices should rise at a greater rate than the general market.

A high P/E stock would be a suitable investment for which of the following investors? A A recent college graduate who is currently renting an apartment and who wishes to buy a house in 5 to 10 years B A recently retired client who has a comfortable level of income from her pension, does not need additional income and is looking for aggressive investing C A young married couple with 3 children ages 10, 12, and 14, who have minimal savings but wish to start putting away money to pay for their kids' college education D A middle-aged single man who was just diagnosed with a disabling medical condition that will likely require him to need nursing care for his remaining lifespan that is not covered by his medical insurance

B A recently retired client who has a comfortable level of income from her pension, does not need additional income and is looking for aggressive investing High P/E stocks are risky. These are high growth stocks that typically pay minimal dividends, and which are expected to grow rapidly in the future. If their growth starts to slow, the price of these stocks can fall dramatically

Which bond portfolio construction is based on a phase-in of purchases in installments over time? A Ladder B Bullet C Barbell D Balloon

B Bullet A bullet portfolio construction only has a single maturity, typically in an intermediate range of around 10 years. The way that interest rate risk is offset here is that all of the investment is not made at one time - rather, the investment is made in installments at fixed intervals. If market interest rates rise, new investment will be made at higher rates, offsetting any loss on the already purchased bonds.

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

B 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.

A 60-year old widow is looking for an investment that will provide safety of principal and a moderate level of income. All of the following recommendations are suitable EXCEPT a(n): A Income mutual fund B Income bond C U.S. Government bond D U.S. Government bond fund

B 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.

All of the following are suitable investments for an Individual Retirement Account EXCEPT: A Corporate bonds B Municipal bonds C U.S. Government bonds D Zero coupon bonds

B 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. Review

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? A Long-Term U.S. Government Bond Fund B S&P 500 Index Fund C High Technology Growth Fund D Special Situations Fund

B 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 customer, age 55, has a diversified portfolio of blue chip equity investments that pay a reliable cash dividend. The customer would like to retire at age 65. The customer has an expensive lifestyle, and even though he makes a good income, he uses the dividend income from his investments to pay his large monthly bills. The main problem that is evident here is that the: A portfolio should be rebalanced to include a percentage allocation to fixed income securities because of the customer's age B customer is unable to take advantage of the compounding effect of reinvesting dividends C customer increases his tax liability by spending the dividends rather than reinvesting them D customer needs to change his spending habits

B customer is unable to take advantage of the compounding effect of reinvesting dividends Choice B is good too - by continually spending the dividends instead of reinvesting them, the customer gives up the compounding effect of adding to his investments each year, which increases dividends received, which can then be reinvested in more shares, which earns even more dividends, etc.

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: A tax-qualified annuities B municipal bonds C securities held in offshore accounts D short-term promissory notes

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.

If one asset class greatly underperforms another class in an asset allocation plan, the portfolio must be: A renegotiated B rebalanced C repositioned D realigned

B 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

An investor has a long-term investment time horizon, no liquidity needs and is very risk averse. Your main concern when making a recommendation to this client is: A preservation of capital B safety of principal C continuing income D adequate yield

B safety of principal Safety of principal is the better answer as a "concern." This type of client doesn't want his or her principal put at risk - he or she is just averse to taking on risk, but can afford to do so. Such a client could be recommended CDs, money market funds, short term bonds and laddered bond portfolios.

An 80-year old client lives on his social security payments that total $25,000 per year. 3 years ago, on the advice of the broker, he invested in a technology fund where he lost most of his assets. The remaining balance in his brokerage account is $17,000. The client has annual living expenses of $30,000 and a net worth of $128,000. The customer approaches a new broker to take over management of his account. The representative that receives the account should: A do nothing B sell the holding in the account and invest the proceeds in a more conservative fund within the same family of funds C sell the holding in the account and invest the proceeds in a more conservative fund outside the family of funds D sell the holding in the account and invest the proceeds in a more conservative fund that has a deferred sales charge

B sell the holding in the account and invest the proceeds in a more conservative fund within the same family of funds Choice B is best because there will be no (or a lower) sales charge for moving assets within a family of funds, as opposed to investing the proceeds in a new fund family.

is specific to the business of that company. For example, a business risk for pharmaceutical companies is losing patent protection on a profitable drug.

Business Risk

A single 30-year old investor has no current investments and $20,000 in a savings account. The customer earns $150,000 per year and has discretionary investment funds of $25,000 per year. Which of the following is an appropriate asset allocation for this customer? A 80% Aggressive Growth Fund, 20% Emerging Markets Fund B 80% Emerging Markets Fund, 20% Aggressive Growth Fund C 30% Aggressive Growth Fund, 30% Emerging Markets Fund, 30% Growth Fund, 10% Money Market Fund D 30% Money Market Fund, 30% Treasury Securities Fund, 30% Blue Chip Stock Fund, 10% Aggressive Growth Fund

C 30% Aggressive Growth Fund, 30% Emerging Markets Fund, 30% Growth Fund, 10% Money Market Fund Since this customer is only 30 years old and is single, he has a long investment time horizon. The question does not provide any detail in terms of the customer's investment objectives and risk tolerance level. However, the concept of asset allocation is that by diversifying across asset classes, overall risk can be reduced while still achieving the customer's objective. A younger customer should be allocated more heavily into growth stocks. Choice C, with a 30% allocation to an Aggressive Growth Fund, 30% to an Emerging Markets Fund, 30% to a Growth Fund, and 10% to a Money Market Fund gives the customer a heavy concentration in growth stocks, but spread across 3 types of growth investment vehicles.

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 As one gets older, portfolio composition should shift to "safer" assets that generate reliable income. The general rule is to take "100 minus the investor's age" to get the appropriate investment portion to be held in stocks. Since these investors are a married couple, ages 60 and 70, this gives either 30% or 40% of the portfolio holding in stocks; with the remaining 60 - 70% of the holding in bonds. Note that a 100% bond holding is not appropriate because people are living much longer and they need the "extra return" that is provided by stocks that can grow in value, on top of the somewhat lower fixed return provided by bonds.

A 25-year old client with a low risk tolerance wishes to invest in bonds. The client has invested in equities before, but has no experience investing in bonds. The BEST recommendation would be: A BB-rated short-term bonds B BB-rated intermediate-term bonds C AA-rated short-term bonds D AA-rated long-term bonds

C AA-rated short-term bonds This client has a low risk tolerance. Therefore, to minimize credit risk, investment grade bonds are appropriate (BBB or higher). To minimize interest rate risk, short-term maturities are better than long-term maturities. Both of these factors will result in a safer bond investment. However, the customer will get a lower yield, but that is not addressed in the question.

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 Customers who are in low tax brackets who are seeking income should be recommended taxable fixed income securities, since these pay a higher rate of interest than tax-free securities. Because the customer is in a low tax bracket, very little of that income will be subject to income tax. Fully taxable investments, where the income is subject to both federal and state income tax, include corporate bonds and bank CDs.

Which of the following would be least important in determining the level of diversification in a corporate bond portfolio? A Bond ratings B Industries represented in portfolio C Domicile of issuers D Maturities of the bonds in the portfolio

C Domicile of issuers The "domicile" of an issuer is the state where the issuer legally resides. It has no bearing on the quality of the issuer's securities. Bond rating, type of industry, and maturity would all be considered when examining the diversification of a bond portfolio.

A young widow who works has a $750,000 net worth and a securities portfolio valued at $200,000. The current asset allocation of the portfolio is 80% equity securities; 8% fixed income securities; and 12% money market securities. In which circumstance should she consider reallocating her portfolio? A If she remarries and her new husband is quite wealthy B If she remains employed at the same job C If she becomes unemployed during a recessionary period D If she remarries and her new husband has young children

C If she becomes unemployed during a recessionary period If she loses her job in a recession and has no spouse, it might be hard to find another job. She will need to use money in the securities portfolio to live and an 80% allocation in equity securities will expose her to stock losses due to the recession and also not give current income. She should reallocate the portfolio, liquidating a good chunk of the equities position and increasing the money market fund allocation so that she can draw on it for income.

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? A Tax deferral B Investment growth C Investment time horizon D Liquidity

C 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).

An investor believes that interest rates will be rising in the future. The MOST appropriate investment is: A Long term U.S. Government Bonds B Real Estate C Money Market Instruments D Blue Chip Stocks

C Money Market Instruments Money market instruments are best because the funds are invested short term, and as the money market instruments mature, the proceeds are reinvested at higher interest rates.

The overall economic performance of developing countries is expected to outpace that of the United States over the coming years. A customer that wishes to profit from this should receive which recommendation and accompanying risk disclosures? A The customer should be recommended a special situations fund, as long as the customer is willing to assume regulatory risk and market risk B The customer should be recommended a specialty fund, as long as the customer is willing to assume credit risk and extension risk C The customer should be recommended an emerging markets fund, as long as the customer is willing to assume political risk and exchange rate risk D The customer should be recommended a sector fund, as long as the customer is willing to assume unsystematic risk and market risk

C The customer should be recommended an emerging markets fund, as long as the customer is willing to assume political risk and exchange rate risk A special situations fund invests in companies that are in turnaround or takeover situations. A specialty fund invests in one industry or geographic area, so this is a possible choice. A sector fund invests in one industry sector. An emerging markets fund invests in securities of countries that are rapidly developing (e.g., a "BRIC" fund - Brazil, Russia, India and China). This is the best of the choices offered.

A retired customer has an existing stock portfolio held in a cash account. He has heard that "leveraging" his portfolio can increase his return. The portfolio holds blue chip stocks that pay current dividends. He wants to transfer the positions to a margin account and use them as collateral to buy more stocks of the same blue chip companies. Which statement is TRUE? A This is an appropriate strategy that will increase the customer's income B This is not an appropriate strategy because the customer's tax liability will increase if the securities appreciate and are sold C This is not an appropriate strategy because the customer's income will decline D This is an appropriate strategy because the customer has the potential for larger capital gains

C This is not an appropriate strategy because the customer's income will decline This customer needs income. If he margins the blue chip stock positions to "double up" on the amount of stock owned (since Regulation T margin is 50%), this does not come for free! He 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 time horizon to be used when constructing a portfolio for a person who will retire in a few years is the: A time remaining until retirement B expected time till the person cannot care for him or herself C expected lifetime of that person D expected lifetime of that person's beneficiaries

C 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.

A constant dollar investment plan is one which: A invests a fixed dollar amount periodically in equity securities B invests a fixed dollar amount periodically in debt securities C maintains a fixed dollar amount of a portfolio's assets in equities D maintains a dollar amount of a portfolio's assets in debt

C maintains a fixed dollar amount of a portfolio's assets in equities Under a constant dollar plan, a portfolio manager sets a dollar level (say $200,000) to be maintained in equity securities. If the value rises to $230,000, the $30,000 excess is invested in debt securities. Conversely, if the equity market value drops below $200,000, bonds are liquidated and invested in equities to bring the equity balance to the constant $200,000.

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

C sell 1,000 shares of XYZZ and buy 10 XYZZ Put Contracts The customer purchased the stock at $40 and it is now trading at $45. If the customer has turned bearish on the stock, sell the position, taking the $5 per share profit. Since the customer wants an "aggressive recommendation to profit from the expected price decline, buy puts.

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: A portfolio rebalancing B strategic asset management C tactical asset management D active asset management

C 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".

A married couple, the husband is age 27 and the wife is 25, have 2 young children, no retirement plan and no investments. Based on this information, an agent should: A tell the clients to establish a Roth IRA B tell the clients to establish 529 plans for their children C talk to the clients about their financial goals D determine that the clients have cash available for investment

C talk to the clients about their financial goals

A new client with no other investment assets has just come into an inheritance of $500,000 of ABCD stock, a blue chip company listed on the NYSE. As the adviser to this customer, your IMMEDIATE concern should be: A whether the company is a candidate for delisting B the possibility that the value of ABCD stock may decline sharply C the lack of diversification of the customer's investment D whether the customer paid any estate tax liability due

C the lack of diversification of the customer's investment This is the client's sole investment. Because this is a blue chip company, it is not likely to be delisted. It is also not likely to suffer a sharp price decline, though this could occur. The immediate concern should be the customer's lack of diversification. If the customer were to sell a portion of the ABCD stock and reallocate it to other investments, the client will reduce overall risk. Review

is the risk that an issuer's credit qualify deteriorates, so its bond (and stock) price falls.

Credit Risk

The risk that the currency in which a foreign investment is valued declines relative to the value of the U.S. dollar (meaning that the U.S. dollar strengthens). The investment becomes worth less in terms of U.S. dollars.

Currency Exchange Risk

Which asset allocation is BEST for a 35-year old single risk tolerant investor looking to achieve the highest returns? A 25% Stocks / 25% Bonds / 25% REITs / 25% Money Markets B 50% Stocks / 50% Bonds C 60% Stocks / 40% Bonds D 95% Stocks / 5% Money Markets

D 95% Stocks / 5% Money Markets The investor is 35 years old, single and risk tolerant. While an argument could be made for any one of the choices offered, the one choice that is clearly different from the others is Choice D - 95% equities and 5% money market instruments. This gives both the greatest growth potential for a relatively young investor along with the greatest risk - and this investor is risk tolerant. The other choices have a fairly large portion of the portfolio allocated to bonds, which do not have any growth potential over a long-term investment time horizon, but also have much lower risk.

A trader liquidates an exchange listed stock position and invests the proceeds in an exchange listed stock index fund. The trader has reduced which risk? A Call risk B Inflation risk C Liquidity risk D Capital risk

D Capital risk Capital risk is simply the risk of losing money. By increasing the number of stocks in a portfolio, this risk is reduced through diversification. This is a major advantage of investing in stock index funds. Call risk does not apply to stocks (because common stocks are non-callable). Stocks, whether held individually or in an index fund, are not as susceptible to inflation (purchasing power) risk as bonds. In times of inflation, corporations can raise prices and maintain profitability. Liquidity risk is the risk that a security can only be sold by incurring large transaction costs and is essentially not applicable to exchange listed securities because the market is so active.

A married couple has a teenage child who has expressed interest in going to a vocational school. They both work, have a moderate level of income and would like to save a modest amount each year for this purpose without the concern of paying taxes on annual account earnings. The best recommendation to this couple is to make an annual contribution to a(n): A 529 Plan B UTMA Account C HSA D Coverdell ESA

D Coverdell ESA Funds in a Coverdell ESA (Education Savings Account) can be used for any type and level of education, so the funds can be used to pay for vocational school. The maximum annual contribution is $2,000, so this matches the couple's desire to save a "modest" amount each year. There is no deduction for the contribution, but the account grows tax-deferred, and distributions to pay for qualified educational expenses are not taxed. Also note that Coverdell ESAs are not available to high earners, which is not a problem here.

A customer who earns $80,000 per year is 35 years old, married to a non-working spouse, has a 5-year-old child, has no retirement savings and does not have a will. This customer receives $250,000 in a single stock as an inheritance from her deceased aunt. What is the first thing that the customer should do? A Set up an IRA account to begin to fund her retirement B Establish a will C Pay any capital gains tax due on the stock position, if this cannot be avoided D Diversify the stock position, because it should not be in a single stock holding

D Diversify the stock position, because it should not be in a single stock holding If the inherited asset is a single stock position, the customer should consider liquidating a portion of that holding and reinvesting the proceeds to create a diversified portfolio. Concentrating an investment in a single stock is too risky for most clients.

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!

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: A Large cap stock holding B TIPS holding C Foreign stock holding D Municipal bond holding

D 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.

Which of the following is the LEAST important factor to consider when constructing an investment portfolio for a high net worth individual? A The portion of the funding that should be allocated to tax-free investments B The portion of the funding that should be maintained in readily accessible funds such as money market instruments C The customer's preference for investing via passively managed index mutual funds or via actively managed mutual funds D The investment philosophy and strategies employed by the fund manager of the chosen mutual fund

D The investment philosophy and strategies employed by the fund manager of the chosen mutual fund

A wealthy, sophisticated investor with a high risk tolerance has just turned extremely bearish 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 floaters D buy leveraged inverse ETFs

D buy leveraged inverse ETFs This customer has just turned "extremely bearish" on the market, meaning he thinks that equities are going to fall rapidly in price. The customer is wealthy, sophisticated, and has a high risk tolerance. The most aggressive choice offered is the leveraged inverse ETF. Assume it is a 300% leveraged inverse ETF based on the S&P 500 Index. If the index falls by 15%, this ETF should rise by 3 x 15% = 45%. (Of course, if the customer is wrong and the index rises, then the customer loses big time!) Also note that an inverse floater is a type of bond where when market interest rates rise, its interest rate "floats" and is adjusted downwards by the increase in interest rates. Thus, when interest rates rise, its interest rate will "float" down (and remember that lower coupon bonds lose value more rapidly in a rising interest rate environment). For the exam, just know that an "inverse floater" is a wrong answer. Review

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: A buy a municipal bond fund B write covered calls C buy Treasuries and zero-coupon bonds D buy stocks and bonds

D buy stocks and bonds 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.

Active portfolio management is: A buying and holding the investments chosen by the Registered Representative B determining the securities to be bought or sold based on investment research performed by the Registered Representative C managing a portfolio to meet the performance of a benchmark portfolio D managing a portfolio to exceed the performance of a benchmark portfolio

D 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.

If a portfolio manager's market sentiment is bullish, then which of the following are appropriate actions? I Cash positions will be decreased II Cash positions will be increased III Investments in stock positions will be decreased IV Investments in stock positions will be increased

I and IV From a "market sentiment" standpoint, a portfolio manager will decrease his or her cash position; and increase the portion of funds invested in securities, when he or she is bullish on the market. Conversely, if the manager is bearish, he or she will increase the cash position and decrease the invested portion of the portfolio. Review

If a portfolio manager's market sentiment is bearish, then which of the following are appropriate actions? I Cash positions will be decreased II Cash positions will be increased III Investments in stock positions will be decreased IV Investments in stock positions will be increased

II and III From a "market sentiment" standpoint, a portfolio manager will increase his or her cash position; and decrease the portion of funds invested in securities, when he or she is bearish on the market. Conversely, if the manager is bullish, he or she will decrease the cash position and increase the invested portion of the portfolio.

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 and III In a period of recession, defensive stocks (stocks unaffected by an overall market downturn, such as pharmaceuticals and food) and investment grade bonds outperform the overall market, since they don't readily lose value. In contrast, in a recession, growth stocks and speculative stocks see their earnings suffer and their stock prices erode accordingly.

An elderly customer seeking extra income who has $100,000 to invest could be recommended which of the following? I The $100,000 purchase of a variable annuity II The $100,000 purchase of dividend paying blue chip stocks in a cash account against which calls are sold III The $200,000 purchase of dividend paying blue chip stocks at 50% margin in a margin account IV The $100,000 purchase of Treasury bonds

II and IV 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. Review

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? I Such a strategy will cause the customer to be subject to a lower level of market risk as compared to a "buy and hold" strategy maintained over a long term time frame 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 III Such a strategy will have more favorable tax consequences 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

II and IV Equity returns can vary greatly over a short-term time frame, so this person is taking on a higher level of market risk. Over a long-term time frame, market risk is not a major issue for equity holders, since, historically equities have performed the best of all asset classes over a long periods of time. Any gains on securities held short term (1-year or less) are taxed at much higher rates (up to 37%) than long term gains (15%, or 20% for high earners).

As interest rates go up, bond prices fall - this is interest rate risk The bonds that are most susceptible to interest rate risk are: Longer maturity issues Low coupon issues

Interest Rate Risk/ Market Risk

is the risk that a security position cannot be easily liquidated. Illiquid securities include limited partnerships, thinly traded domestic OTC stocks, and foreign stocks of companies in developing countries.

Liquidity Risk

is the risk of an overall market decline bringing down all stock prices - but all stocks are not equally affected. For example, defensive stocks will not decline in value as much as growth stocks when there is an overall market decline.

Market Risk

is associated with investing in Third World countries with weak political systems, so investors are not as well protected against negative government actions, such as the government "nationalizing" the company you invested in.

Political Risk

associated with preferred stocks, bonds, and mortgage backed securities held over long time frames. To maintain a portfolio's rate of return, any dividend or interest payments received from the securities held in the portfolio must be reinvested at the same rate. If interest rates are dropping over the investment time horizon, then any payments from these securities are reinvested at lower and lower rates, reducing the overall portfolio return over time.

Reinvestment Risk

is the risk of inflation. This will force interest rates up and securities prices down. Not only will fixed income securities' prices fall, but common stocks tend to fall as well, since companies typically cannot raise prices fast enough to keep pace with increasing inflation, and profits suffer.

Repurchasing Power Risk