CFP Investment Planning M8 Portfolio Management Theory, Portfolio Development, Asset Allocation

Phil has computed a required return for the Pepsi stock he is considering purchasing. He believes that interest rates and inflation will change over the expected holding period. Therefore, he adjusted the required return for his projected changes in these factors. Which of the following stock market theories did Phil use? A) Dividend growth theory B) Arbitrage pricing theory C) Black-Scholes pricing theory D) Modern portfolio theory

Explanation An investor using the APT starts with a required return for a security, possibly computed using the CAPM. The investor then adjusts the required return for a multitude of factors that may affect that particular security, such as interest rates, industrial production, and inflation. LO 8.2.1

An active portfolio strategy is based on which of the following premises? A) The investor's ability to obtain public information B) The stock market is efficient C) The portfolio manager's access to corporate management D) The stock market is inefficient

Explanation If the market is efficient, then a buy-and-hold strategy would be best. Only if the market is inefficient is it worth the costs involved in active management to attempt to generate superior returns. LO 8.3.2

Assume that the economic forecast for the coming year is expected to be one of increasing inflation and interest rates. The GDP is expected to be strong. Which of the following types of investments would be advisable for the coming year and why? Liquid investments, such as money market funds and short-term securities, to allow the investor flexibility to reinvest as rates increase Long-term debt, such as 20-year government bonds, to lock in current interest rates Stock in public utilities and durable goods firms, becausethey benefit from a rising interest rate environment Tangible assets, such as gold, to keep pace with the rate of inflation A) I, II, and III B) I and IV C) II and IV D) I, III, and IV

Explanation Long-term bonds decrease in value in a rising interest rate environment. Stock in public utilities and durable goods firms does not benefit from a rising interest rate environment. LO 8.5.1

Which of the following statements regarding an efficient portfolio is CORRECT? Provides the highest return for a given level of risk Has the greatest risk for a given level of expected return Shows an investor's willingness to bear risk Can be created with minimum transaction costs A) II and III B) I, II, and III C) III and IV D) I only

Explanation The answer is I only. An investor should try to assemble an investment portfolio containing the optimum combination of risk and return. An efficient portfolio offers maximum return for a given level of risk. An investor's willingness to bear risk is reflected in indifference curves. LO 8.1.1

In order to do an effective job of investment counseling, which of the following should be analyzed and reviewed? Financial goals Client tax situation Client financial statements Client preferences, investment understanding, and experience A) I only B) I, II, and III C) I and III D) I, II, III, and IV

Explanation The answer is I, II, III, and IV. All of these are parts of a comprehensive client analysis. In addition, the planner should discuss the risk tolerance and risk exposure of the client and the liquidity needs and the investment time horizon of the client. LO 8.5.1

Which of the following statements about the efficient market hypothesis (EMH) and associated anomalies are CORRECT? An investor purchasing a high price-to-earnings (P/E) ratio is exploiting the P/E effect anomaly. An investor studying annual reports and analysts' reports in his stock selection process believes that markets are weak-form efficient. An investor who buys the securities of firms that are not followed by many analysts is trying to benefit from the neglected-firm effect. An investor who befriends the chauffeur of a firm's CEO to solicit information about the firm's plans before making investment decisions believes the markets are strong-form efficient. A) I and II B) II and III C) III and IV D) I and III

Explanation The answer is II and III. The P/E effect suggests that portfolios consisting of stocks with low price-to-earnings ratios have higher average returns than do portfolios consisting of stocks with high P/E ratios. Strong-form market efficiency suggests that all public and private information is included in market prices. A person who solicits private information believes that it is possible to profit by making trading decisions based on private information and does not believe that the markets are efficient in the strong form. Weak-form efficiency suggests that all historical price and volume information is included in stock prices but that gains may be made by analyzing other publicly available information. An investor studying annual reports and analysts' reports to make stock selections indicates that the person is conducting fundamental analysis, because the investor believes that the markets are weak-form efficient. LO 8.3.1

Which of the following should be agreed upon between the client and the investment professional when making recommendations based on an investment policy statement? A) Return requirement B) All of these C) Risk tolerance D) Permitted and excluded investments

Explanation The answer is all of these. The client and the investment professional should agree on return requirement, risk tolerance, and permissible investments. Other factors to incorporate are liquidity needs, asset allocation, time horizons, tax considerations, and laws and regulations. LO 8.4.1

John, your client, received notice that he will be laid off from his job in one month due to his company downsizing as a result of a slowing economy. What would be the best course for your client after his job loss? A) Cancel his health insurance. B) Cash in a growth mutual fund with a large unrealized capital gain. C) Apply for unemployment benefits. D) Take a loan from his 401(k) plan to pay for current expenses.

Explanation The answer is apply for unemployment benefits. Cancelling his health insurance without reviewing any COBRA options would not be prudent. He will not be able to take a loan from his 401(k) plan after he terminates his employment. Cashing in his mutual fund may not be wise because any unrealized gain would become taxable. LO 8.6.1

An investor considering investing in a particular security is more concerned with A) expected return. B) historical return. C) trailing P/E ratio of the stock. D) actual return.

Explanation The answer is expected return. Expected return is what determines an asset's value. The expected return must be greater than the investor's required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return. LO 8.2.1

Under the efficient market hypothesis, which of the following terms best describes the movement of stock prices? A) Predictable B) Statistical C) Random D) Diverse

Explanation The answer is random. Random walk is the term used to describe the pattern of movement of stock prices. Because only new information, which is unpredictable and random, will affect the price of a security, the pattern of price movements for a stock will be random. LO 8.3.1

Which of the following factors is NOT necessary for calculating the measure of risk that is used in Markowitz's efficient frontier? A) Beta for each asset class B) Correlation between each asset class and every other asset class C) Standard deviation for each asset class D) The percentage of the portfolio invested in each asset class

Explanation The efficient frontier consists of efficient portfolios. An efficient portfolio has the highest return for a given level of risk. The risk measure is standard deviation; specifically, the standard deviation of a multi-asset portfolio. The other choices represent inputs needed to determine the standard deviation of a multi-asset portfolio. Beta is not used in the calculation. LO 8.1.1

The weak form of the efficient market hypothesis: reinforces the value of technical analysis. implies that technical analysis is not worthwhile. implies that fundamental analysis is not worthwhile. implies that inside traders cannot earn superior risk-adjusted returns. A) I, III, and IV B) I and IV C) II only D) II and III

Explanation The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits. LO 8.3.1

Roger is willing to invest in securities with above-average risk if he is rewarded for doing so. He has been following the stock of a company that he likes, but is concerned because the stock dropped 9% the last time the S&P 500 dropped 7%. Roger believes that an 11% return for the market next year would be good. The current market risk premium is 7.5% and the Treasury bill rate is 5.75%. The stock Roger has been following has the following characteristics: Standard deviation 18% Dividend yield 2.4% P/E ratio 17 P/E ratio relative to S&P 500 1.4 Beta 1.25 Using the CAPM formula, calculate the required rate of return for the stock and determine if the stock appears to meet Roger's criteria of investing in above-average-risk stocks only if he is rewarded for doing so. A) The required rate of return is 13.25%, and the stock meets Roger's criteria. B) The required rate of return is 15.13%, and the stock meets Roger's c

Required rate of return is 5.75% + (7.5%)1.25 = 15.13%. The fact that Roger believes 11% would be a good return is not relevant for computation of the required rate of return—only the computed market risk premium is relevant. The market return is computed as 7.5% + 5.75% = 13.25%. Roger will invest in an above-average risk stock (beta = 1.3) if he can be rewarded for taking the extra risk. The reward is the greater-than-market return of 15.13%. LO 8.2.1

Mike, a stock analyst, has determined several factors affecting the expected return on a stock. In addition, he has estimated their sensitivity coefficients and associated risk premiums. Factor Sensitivity Coefficient Risk Premium Unemployment 0.7 6% Inflation 0.8 4% Demand 1.2 5% Assuming the current risk-free rate of return is 3%, calculate the expected return of the stock using the arbitrage pricing theory (APT). A) 13.40% B) 18.00% C) 12.20% D) 16.40%

The answer is 16.40%. The stock has an expected return of 16.40%, calculated as follows: using APT, ri = 0.03 + (0.7 × 0.06) + (0.8 × 0.04) + (1.2 × 0.05) = 0.1640, or 16.40%. LO 8.2.1

Calculate the expected rate of return for a stock with a beta of 2.0 when the risk-free rate is 6% and the return on the market is 12%. A) 10% B) 18% C) 24% D) 12%

The answer is 18%. Using the capital asset pricing model (CAPM), the expected rate of return is 18% [6% + (12% - 6%)2.0]. LO 8.2.1

Select the CORRECT statements concerning the analysis of portfolio risk. Investors estimate the risk of a portfolio on the basis of the variability of returns. Markowitz used risk and expected return as the basis for determining efficient combinations of assets. For a given level of risk, investors prefer lower returns to higher returns. Investors base decisions solely on expected return and risk. A) II and III B) II, III, and IV C) I only D) I, II, and IV

The answer is I, II, and IV. Only statement III is incorrect. For a given level of risk, investors prefer higher returns to lower returns. LO 8.1.1

The weak form of the efficient market hypothesis reinforces the value of technical analysis. implies that technical analysis is not worthwhile. implies that fundamental analysis is not worthwhile. implies that inside traders cannot earn superior risk-adjusted returns. A) II and III B) I and IV C) II only D) I, III, and IV

The answer is II only. The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits. LO 8.3.1

The current risk-free rate of return is 4%, and the market risk premium is 5%. One stock under consideration for investment has a beta of 1.3. Calculate the expected rate of return for both the market portfolio and the individual stock. A) Market = 9.00%; Stock = 10.50% B) Market = 10.50%; Stock = 9.00% C) Market = 6.92%; Stock = 11.70% D) Market = 11.70%; Stock = 10.50%

The answer is Market = 9.00%; Stock = 10.50%. The expected rate of return for the market portfolio is 9%, calculated as follows: Using the capital asset pricing model (CAPM), rp = 4% + (5% × 1.0). The market has a beta of 1.0 and the market risk premium, rather than the market return, is given. The expected rate of return for the stock is 10.50%, calculated as follows: Using CAPM, ri = 4% + (5% × 1.3) = 10.50%. LO 8.2.1

Which statement regarding the concepts of modern portfolio theory (MPT) is NOT correct? A) Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. B) An infinite number of portfolios exist on the efficient frontier. C) For any given level of risk, investors prefer higher returns to lower returns. D) Indifference curves represent the risk-reward trade-off that investors are willing to make.

The answer is Markowitz used risk (as measured by beta) and expected return as the basis for determining appropriate assets or portfolios. Harry Markowitz's theory uses standard deviation as a measure of portfolio risk. LO 8.1.1

Which of the following would cause the risk premium an investor expects to earn on a stock to increase when using the capital asset pricing model (CAPM)? A) An increase in beta B) A decrease in covariance C) An increase in the correlation coefficient D) An increase in standard deviation

The answer is an increase in beta. All other factors remaining equal, an increase in beta will cause the risk premium to increase. In addition, the resultant expected rate of return will increase. LO 8.2.1

An investor selects an appropriate portfolio by choosing the portfolio A) with the highest return. B) at the point of tangency between the indifference curve and the efficient frontier. C) with the lowest risk. D) that lies below the efficient frontier.

The answer is at the point of tangency between the indifference curve and the efficient frontier. The investor will choose a portfolio represented by the highest point attainable on the indifference curve. LO 8.1.1

Which of the following statements regarding asset allocation is CORRECT? Asset allocation is the main determinant of a portfolio's total return. The purpose of strategic asset allocation is to determine an appropriate allocation based on the long-term financial goals of the client. A) Neither I nor II B) Both I and II C) II only D) I only

The answer is both I and II. Both of these statements are correct. LO 8.5.2

The semistrong form of the efficient market hypothesis states that current market prices reflect all available information on the history of prices. all publicly available information concerning a company. A) II only B) Neither I nor II C) Both I and II D) I only

The answer is both I and II. The semistrong form states that all publicly available information, including past stock price history, is reflected in current stock prices. LO 8.3.1

After suffering an unexpected job loss and losing a $125,000 annual salary, your client, Joe, comes to you to review his asset allocation. In addition to possibly having a prolonged unemployment period, Joe, age 62, would like to retire within eight years. He is concerned about the allocation of the Section 401(k) plan at his prior employer which is 100% invested in an S&P 500 Index fund. The balance of the account is $2,500,000. Based on this information, what should you do next? A) Tell Joe to focus on finding a job and not be concerned with his asset allocation. B) Have Joe complete any necessary paperwork to transfer his 401(k) plan assets to an IRA. C) Discuss Joe's risk tolerance and make appropriate changes to his plan's asset allocation. D) Recommend Joe apply for early Social Security benefits to provide him with income during his job search.

The answer is discuss Joe's risk tolerance and make appropriate changes to his plan's asset allocation. With retirement looming on the horizon, Joe should consider reducing the risk exposure in his retirement plan. Moving the 401(k) to an IRA could be a consideration, but this should not be an immediate planning recommendation. Recommending he take early Social Security benefits may not be prudent due to tax issues and locking in a lower monthly benefit for life. LO 8.6.1

Which of the following statements about the importance of risk and return in the investment objective is least accurate? A) The investor's risk tolerance is likely to determine what level of return will be feasible. B) The return and risk objectives have to be consistent with reasonable capital market expectations, as well as the client constraints. C) The return objective may be stated in dollar amounts even if the risk objective is stated in percentages. D) Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return.

The answer is expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible. LO 8.5.1

All of the following statements concerning market efficiency are correct except A) an efficient market is one in which the prices of securities quickly and fully reflect all available information. B) the weak form of market efficiency involves market data, whereas the semistrong involve the assimilation of all public information and the strong form involves both public and and private information. C) the efficient market hypothesis states that securities markets are efficient, with the prices of securities reflecting their current economic value. D) investors usually react slowly to new and random information pertaining to securities markets.

The answer is investors usually react slowly to new and random information pertaining to securities markets. Another condition that guarantees an efficient market is investors reacting quickly to new information. LO 8.3.1

All of the following illustrate a characteristic of a Monte Carlo simulation except A) the user gets a best-case scenario and a worst-case scenario. B) a clearer understanding of short-term and long-term risk can be gained. C) the simulation provides insight into the range of outcomes. D) large changes in the projected rate of return will make small differences in the outcome.

The answer is large changes in the projected rate of return will make small differences in the outcome. Small changes in the projected rate of return will make large differences in the outcome. LO 8.4.1

Your client is concerned that the stock market is overvalued and may experience a large market correction within the next year. The client is 45 years old, has significant retirement savings, little debt, and no dependents. The current retirement portfolio mix is 80% stock/20% fixed-income. What is the best course of action for your client to take regarding this concern? A) Liquidate the retirement portfolio and reposition the proceeds into cash. B) Maintain a long-term perspective and consider keeping the current portfolio allocation. C) Reposition all stock investments into fixed-income investments. D) Reallocate the retirement plan proceeds into a conservative target asset allocation portfolio focused on U.S. Treasuries.

The answer is maintain a long-term perspective and consider keeping the current portfolio allocation. When confronted with financial or economic crisis events, the best course of action is for clients to keep a long-term perspective and focus on long time horizons rather than reacting negatively to market events. LO 8.6.1

Which of the following statements regarding the arbitrage pricing theory (APT) is CORRECT? A) The risk-free rate of return does not affect the return. B) Inflation is not a pricing factor. C) Beta is a pricing factor. D) Multiple factors affect the return of a security.

The answer is multiple factors affect the return of a security. The APT determines returns based on multiple factors. These factors might include inflation, growth in GDP, major political upheavals, or changes in interest rates. LO 8.2.1

Which of the following statements regarding the capital market line (CML) is CORRECT? A) Is not useful for diversified portfolios B) Provides a direct relationship between the risk and return for a well-diversified portfolio C) Describes the required return of individual stocks D) Uses beta as a risk measure

The answer is provides a direct relationship between the risk and return for a well-diversified portfolio. The capital market line (CML) graphically depicts the relationship of risk and return for efficient well-diversified portfolios. The CML uses standard deviation as a risk measure. LO 8.2.1

Which of the following is NOT likely to be an advantage of a valid investment policy statement? A) Identifies and documents investment objectives and constraints B) Allows for a continual dynamic process in meeting investor objectives C) Promotes long-term discipline in investment decisions D) Provides for short-term strategy shifts in response to short-term dramatic value declines

The answer is provides for short-term strategy shifts in response to short-term dramatic value declines. The investment policy statement does not provide for shifts in strategy due to short-term value declines. LO 8.4.1

Identify the efficient market hypothesis that suggests an investor can achieve above-market returns by only utilizing insider information. A) All of these forms B) Strong C) Semistrong D) Weak

The answer is semistrong. The semistrong form suggests that fundamental analysis is of no value and only through the use of insider information can an investor achieve above-market returns. LO 8.3.1

Your client has established a balanced portfolio with various amounts allocated to different asset classes, and periodically she rebalances the portfolio to keep the same approximate percentages in these asset classes. Her approach is A) core-satellite asset allocation. B) dynamic asset allocation. C) strategic asset allocation. D) tactical asset allocation.

The answer is strategic asset allocation. Strategic asset allocation involves re-balancing back to the original allocation and adjusting the allocation based on changing client circumstances. Tactical asset allocation involves choosing various sectors that you believe will do best, and changing as you believe is necessary. Dynamic asset allocation changes the allocation amounts as the market changes, typically used by institutional investors. Core-satellite asset allocation is a combination of strategic and tactical. LO 8.5.2

An investor who reallocates her portfolio frequently to take advantage of perceived opportunities in other market sectors is using which one of the following types of asset allocation? A) Strategic B) Tactical C) Passive D) Dynamic

The answer is tactical. Reallocating a portfolio frequently to take advantage of perceived under- or overvaluations in a particular market is tactical asset allocation, which is akin to market timing. Strategic asset allocation involves determining the best risk/return portfolio for an investor and then rebalancing to that optimum mix when percentages change due to market movements. The dynamic strategy is used by institutions, and involves increasing risky assets as the portfolio value rises, and decreasing risky assets as the portfolio value declines. LO 8.5.2

All of the following affect an investor's risk tolerance except A) investment time horizon. B) family situation. C) years of experience with investing in the markets. D) tax bracket.

The answer is tax bracket. Tax concerns play an important role in investment planning; however, these constitute an investment constraint, not an investment objective (i.e., risk tolerance). LO 8.4.1

In a financial market A) that is efficient, the prices of securities will not differ from their justified economic values for any length of time. B) investors who do not believe in the efficient market hypothesis (EMH) will stop seeking undervalued securities. C) that is efficient, new information will be slowly reflected in securities prices. D) investors will take an active investment strategy if they are strong believers in the efficient market hypothesis (EMH).

The answer is that is efficient, the prices of securities will not differ from their justified economic values for any length of time. An efficient market is a market that quickly reflects all new information. Accordingly, security prices will not depart from their justified economic value for any extended period. Investors who are strong subscribers to the EMH will be passive investors. On the other hand, investors who do not believe in the EMH will become active investors and will seek to identify undervalued securities. LO 8.3.1

All of the following statements correctly explain the core and satellite approach to investing except A) core investments may include U.S. stocks, U.S. fixed-income, and developed international equities. B) the core and satellite investment strategy has the client invest in both broad market indexes (core) and higher-risk alternatives (satellite). C) the core portion of the portfolio uses an active investment philosophy to achieve above-market returns. D) one goal of this strategy is to reduce portfolio risk through diversification.

The answer is the core portion of the portfolio uses an active investment philosophy to achieve above-market returns. The core portion of the portfolio uses a passive investment philosophy to achieve market-based returns, while the satellite portion of the portfolio uses active investment management in an attempt to achieve above-market level returns. LO 8.5.2

All of the following are primary factors in the arbitrage pricing theory (APT) except A) unemployment rate. B) changes in GDP. C) inflation rate. D) interest rates.

The answer is unemployment rate. These factors might include inflation, growth in GDP, major political upheavals, or changes in interest rates. LO 8.3.2

Which of the following statements regarding the efficient market hypothesis (EMH) is CORRECT? The EMH suggests that active management should be used. Under the EMH, all publicly known information is incorporated into security A) II only B) I only C) Neither I nor II D) Both I and II

a The answer is II only. The EMH suggests that passive, not active, management should be used. LO 8.3.2

A firm declares a $3.00 cash dividend to its shareholders. The firm has issued dividends of only $0.07 per share for each of the last 15 quarters, and market analysts anticipate a similar dividend this quarter. In an efficient market, one would expect A) a price change upon the announcement. B) a price increase before the announcement. C) no price change before or after the announcement. D) a price decrease after the announcement.

a The answer is a price change upon the announcement. In an efficient market, the price of the stock will represent all public information. Because the increase in the dividend was not public knowledge until it was declared, no price change would take place before the announcement. A price change, representing the increase in dividends, would be expected immediately after the information became public. LO 8.3.2

The random walk hypothesis is supported when future price changes are not correlated with past price changes. stock price changes are random but predictable. stock prices respond rapidly to new information. past information is not useful in predicting future price changes. A) I, II, and IV B) I, III, and IV C) III only D) II, III, and IV

b Explanation The answer is I, III, and IV. The random walk hypothesis assumes that stock price changes are essentially random, and therefore unpredictable; or that successive stock returns are independent of past returns. Stock prices react quickly to new information. Past information is not relevant when predicting future price changes, hence, future price changes are not correlated with past price changes. LO 8.1.1

Which of the following statements describes a limitation of Monte Carlo simulation? A) A clearer understanding of short-term and long-term risk can be gained. B) Outcomes of a simulation can only be as accurate as the inputs to the model. C) Simulations do not consider possible input values that lie outside of historical experience. D) Variables are assumed to be normally distributed but may not be normally distributed

b Explanation The answer is outcomes of a simulation can only be as accurate as the inputs to the model. Monte Carlo simulations can be set up with inputs that have any distribution and any desired range of possible values. However, a limitation of the technique is that its output can only be as accurate as the assumptions an analyst makes about the range and distribution of the inputs. LO 8.4.1

Richard has become very interested in the stock market and enjoys spending his spare time researching companies in the medical field. He believes studying and analyzing the industry, combined with his advanced exposure to trends and new innovations in medicine, will give him an advantage in achieving superior performance in medical stock investment opportunities. Choose the form of the efficient market hypothesis (EMH), if any, that Richard is considered subscribing to. A) Strong form B) Semistrong form C) Weak form D) None of these

c Explanation Richard is subscribing to the weak form of the EMH because he believes fundamental analysis and insider information will yield superior performance. LO 8.3.1

Which of the following statements regarding the capital asset pricing model (CAPM) are CORRECT? Standard deviation is used as the measure of risk on the security market line. The capital asset pricing model formula defines the security market line. Superior performance opportunity exists if a fund's position is above the security market line. Both portfolio risk and return decrease when investors substitute risky securities for risk-free assets. A) II, III, and IV B) I, II, and IV C) II and III D) I and IV

c Explanation The answer is II and III. Beta is used as the measure of risk on the security market line. If risky securities are added to the portfolio, both risk and return will increase. The capital market line slopes upward indicating that as more risk is undertaken, more return should be achieved. LO 8.2.1

The security market line (SML) A) indicates the market portfolio as the only optimal portfolio. B) plots diversifiable risk on the horizontal (X) axis. C) shows a security's expected return as a function of its systematic risk. D) presents the relationship between a security's return and the return of the market portfolio.

c Explanation The answer is shows a security's expected return as a function of its systematic risk. The security market line (SML) shows the relationship between the rate of return and systematic risk (beta). Thus, the SML depicts a security's expected return as a function of its systematic risk. The intersection between the efficient frontier and a line from the risk-free rate depicts all the optimal portfolios composed of a combination of the market portfolio and the risk-free asset. The market portfolio is the only optimal portfolio comprised solely of risky securities. LO 8.2.1

Which of the following statements concerning the purpose of an investment policy statement is CORRECT? An investment policy statement is a written document that establishes client objectives and sets limitations on the investment manager. The investment policy statement can be used as the basis to measure the manager's performance against the stated objectives and constraints. Possible investment strategies that should be pursued by an investment adviser on behalf of the client begin with the formulation of a complete and thorough investment policy statement. An allocation among asset classes and their respective weights is a part of any investment policy statement. A) II and IV B) I, III, and IV C) I, II, III, and IV D) I and III

c The answer is I, II, III, and IV. All of these statements are correct. In addition, the investment policy statement can be provided to the portfolio manager to use in establishing and managing the characteristics of the client's portfolio. LO 8.4.1

Indifference curves, which represent the risk-reward trade-off that the investor is willing to make, will cross the efficient frontier in two locations. lie tangent to the efficient frontier. will not intersect the efficient frontier. A) I and II B) I only C) I, II, and III D) II and III

c The answer is I, II, and III. The portfolio that lies at the point of tangency of an indifference curve and the efficient frontier is the optimal portfolio for the investor. LO 8.1.1

Identify which of the following statements regarding the risk premiums associated with the capital asset pricing model (CAPM) are CORRECT. The stock risk premium is the inducement necessary to entice the individual to invest in a given stock. The market risk premium is the incentive required for the individual to invest in the securities market. A) II only B) Neither I nor II C) Both I and II D) I only

c The answer is both I and II. Statements I and II are both correct. The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock, whereas the market risk premium is the incentive required for the individual to invest in the securities market in general. LO 8.2.1

All of the following should be found in an investment policy statement (IPS) except A) the client's liquidity needs. B) the client's risk tolerance. C) the client's time frame. D) the actual investments.

d Explanation The answer is the actual investments. Risk tolerance, time frame, and liquidity needs should all be found in the IPS; investments are not found in the IPS. The IPS is a roadmap and provides guidance for the adviser and client as to the type of investments that will be used (such as 15%-20% in large-cap U.S. stocks), but the actual investments are not specified in the IPS. LO 8.4.1

Which of these best describes the concept of asset allocation? A) The process of purchasing securities over time by investing a predetermined amount at regular intervals B) A written document that sets forth a client's investment objectives and limitations on the investment manager C) Dividends being automatically invested back into the investment from which they were earned D) The process of apportioning assets available for investment among various investment classes

d The answer is the process of apportioning assets available for investment among various investment classes. Asset allocation is the main determinant of a portfolio's total return. Historically, these investment classes have consisted of cash and cash equivalents, equities (stock), and debt (bonds). However, recently (and more properly), the potential investment classes have been broadened to also include real estate, international investments, collectibles, and precious metals. LO 8.5.2