Module 6

a) True

a) True

b) False

The standard deviation—not the riskiness of a portfolio—will decline, but only toward the standard deviation of the market portfolio.

b) False

Studies of risk tolerance show that clients may have different degrees of risk tolerance for different investment goals.

a) True

b) False

Recent studies of employees who were offered 401(k) programs through their jobs found that the more choices the employees had, the less likely they were to participate in any program at all! In other words, too much choice appeared to produce "analysis paralysis."

a) True

a) True

b) False

Because human capital tends to dwarf financial assets for younger workers, the degree of diversification for the financial assets is somewhat immaterial.

b) False

The longer the time horizon, the greater the potential variability of the holding period return. Hence all investors should not consider only the riskiest portfolios.

a) True

a) True

b) False

It is tactical, not strategic, asset allocation decisions that are made for the purpose of beating the market.

b) False

It can make a substantial difference in the final value of the portfolio as to whether a person makes his or her investment at the start or the end of the year.

b) False

Increasing the risk exposure will result in a client holding a portfolio that is riskier than what he or she wants. Furthermore, the additional risk might compound the problem of poor portfolio performance.

b) False

The problem with this strategy is that it might not produce the asset allocation weights that are considered appropriate for the client.

a) True

a) True

a) True

A) a few broad asset categories, a range of weights, and analogous to selecting a portfolio on the efficient frontier.

The others are incorrect because they all contain elements of tactical asset allocation activities, which include a large number of asset categories, precise weights, and an intention to "beat" the market.

D) If stocks are sold to provide the cash to make the loan, then making the loan increases the percentage of the 401(k) portfolio invested in debt.

Under some circumstances, borrowing from a 401(k) may be a good strategy.

The trustee is obligated to set a market interest rate on such a loan.

In some cases the interest rate paid on such a loan may be as good as or better than the rate of return that would have been received.

B) Both I and II

Paying down the principal on a mortgage is analogous to a conservative investment. Hence, clients who are young (and thus have the capacity of taking on risk) and aggressive (by nature) would be good candidates to minimize prepayment of principal on a mortgage.

D) The capital market line lies beneath the efficient frontier.

The capital market line by definition is the efficient frontier. If one considers the efficient frontier that could be created without a risk-free asset, then the capital market line lies above this frontier. This is because it is formed by the line emanating from the risk-free rate of return that is tangent to the efficient frontier without the risk-free asset.

A) The more choices a person has regarding investment opportunities, the more likely that person is to invest.

Research has repeatedly shown that more choices lead to "analysis paralysis," that is, a lack of action.

A) A person’s human capital declines with each year worked.

In the early years of a person’s career, his or her human capital actually grows with the passage of time because the increase in the present value of the higher earning years is greater than the income received each year.

C) II only

I is incorrect because investments solely in stock when there are long time horizons still involve some risk of graver results than conservative investments would yield.

B) The efficient frontier is constructed using a mathematical tool known as quadratic programming.

MPT makes the assumption that one can identify for each pair of securities the covarianceof the returns for those two securities.

If the covariance for two securities is large and negative, the prices of the two securitieswould almost always move in the opposite direction.

MPT is based on the premise that all investments may be characterized with two basicnumbers – expected returns and standard deviations of these returns.

A) The capital market line is a line formed by combinations of the market portfolio and thesecurities market line.

The capital market line is a line formed by combinations of the market portfolio (M) and the risk-freeasset.

B) Negatively correlated assets are necessary to reduce the risk of portfolios.

As long as the correlation coefficient between assets is less than 1, the risk of the portfolio will bereduced. The word “necessary” makes this choice incorrect.

C) Only I.

II is incorrect. The optimal portfolio size is inversely related to the magnitude of the commission one pays.

C) Unsystematic risk.

Unsystematic risk is risk that can be reduced or eliminated through diversification.

D) If the consequences of a decision will be known soon, the decision maker will be relativelymore risk averse.

Generally, individuals are willing to take on more risk if they have a long-term time horizon.

Investors should generally take on more risk with their retirement portfolio than withportfolios associated with other goals.

Individuals tend to be the most risk averse when the amount at risk is large.

Studies have shown that even after an individual overcomes a fear through training, the fear does not disappear completely.

A) Neither I nor II.

D) Investors should attempt to minimize the correlation between their human capital and their financial assets.

Human capital refers to an individual’s capacity to generate income.

A simple way to define an individual’s wealth is to add their human capital and theirfinancial assets.

When individuals begin their career, their wealth mostly consists of their human capital.

C) The greater the standard deviation, the greater the spread between the geometric mean returnand the arithmetic mean return for a given security.

The arithmetic mean rate of return can be misleading because it reflects the average, noteffective, rate of return over time.

The geometric mean return and the arithmetic mean return for a given security will beequal when all per period return relatives (PPRRs) are equal.

The geometric mean return is the effective annual rate of return over multiple time periods.

• There is a 95% probability that the actual return will fall within two standard deviations from the arithmetic mean. As a result:
• Low return= 8% - [6%*2] = (4%)
• High return= 8% + [6%*2] = 20%

B) Investors will periodically modify their asset allocation based on their time horizon.

Samuelson has shown that under certain circumstances, investors will hold the same asset allocationregardless of time horizon.

B) Neither I nor II.

I is incorrect. The constant relative risk aversion assumption assumes that a person has the same risktolerance despite the amount of wealth accumulated. Empirical evidence indicates that this is NOT thecase.

II is incorrect. The random walk theory states that returns each year are completely independent of theprior year’s returns. Mean reversion process means that a particularly high rate of return in one periodwill typically be followed by a particularly low rate of return in the next period.

D) Only II.

I is incorrect. Investors should consider several portfolios, including those that are not as risky.

A. A planner following this allocation method may choose index funds for a client.

Strategic asset allocations are normally made with broad asset categories.

The purpose of strategic asset allocation is to determine the portfolio’s overall riskexposure.

Strategic asset allocation decisions are made only occasionally.

A. These decisions are made more frequently than strategic asset allocation decisions.

Tactical asset allocations use more asset categories than strategic asset allocation.

The purpose of tactical asset allocation is to outperform the market.

Board of trustees should use strategic asset allocation.

C) Tactical asset allocation decisions typically include many more asset categories than strategic asset allocation decisions.

Tactical asset allocation decisions are typically made more frequently than strategic assetallocation decisions.

Tactical asset allocation decisions are made for the purpose of beating the market.

Financial planners who believe in the efficient market hypothesis would not necessarilyengage in tactical asset allocation. Tactical asset allocation decisions imply that the planner believes they can outperform other investors, which is inconsistent with the efficient market hypothesis.

D) One problem with computing covariance is there is no standard of comparison.

A concentrated portfolio will expose the investor to non-market risk. All investors areexposed to market risk.

In order to achieve diversification, an investor must hold securities whose correlation coefficients are low.

The Woerheide-Persson diversification index does not consider the extent to which stocksin a portfolio are related.

C) Only I.

II is incorrect. Mutual funds are generally considered tax-inefficient, and this is one of the primaryarguments AGAINST investing in mutual funds.

D) Higher investment rates of return tend to lengthen the BHP.

Higher investment rates of return tend to shorten the BHP because the deferral of taxation becomes moreattractive.

C) Both I and II.

D) Both I and II.

D) Dollar cost averaging is a passive method of investing that can help individuals overcome theirfear of investing.

Dollar cost averaging involves the investment of a fixed dollar amount at specific time intervals.

Dollar cost averaging usually results in a lower average purchase price per share, becausemore shares are purchased when the price is low and fewer shares are purchased when the price is high.

It will not protect investors in the case of a steadily declining market.