Module 6

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  1. Investors should only consider portfolios on the efficient frontier.

    a) True
    b) False
    a) True
  2. The capital market line is created by combining the market portfolio and the risk free asset.

    a) True
    b) False
    a) True
  3. The riskiness of a portfolio declines as more and more securities are added to it until the portfolio becomes almost risk free.

    a) True
    b) False
    b) False

    The standard deviation—not the riskiness of a portfolio—will decline, but only toward the standard deviation of the market portfolio.
  4. The degree of a client's risk tolerance is unaffected by any specific investment objective.

    a) True
    b) False
    b) False

    Studies of risk tolerance show that clients may have different degrees of risk tolerance for different investment goals.
  5. If the consequences of the decision will be known right away, the decision maker generally will be relatively more risk averse than if the consequences of the decision will be unknown for some time.

    a) True
    b) False
    a) True
  6. The more choices offered to an investor, the more likely he or she is to invest.

    a) True
    b) False
    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."
  7. When a person is retired, his or her wealth is measured strictly by his or her financial assets.

    a) True
    b) False
    a) True
  8. The value of human capital will actually grow for most of a person's working career if he or she receives steady increases in wage income.

    a) True
    b) False
    a) True
  9. Diversification is important even for younger people making their first investment.

    a) True
    b) False
    b) False

    Because human capital tends to dwarf financial assets for younger workers, the degree of diversification for the financial assets is somewhat immaterial.
  10. Because of time diversification, people with long time horizons should always consider only the riskiest possible portfolios.

    a) True
    b) False
    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.
  11. Constant relative risk aversion is an academic term to describe the assumption that a person has the same risk tolerance despite the amount of wealth that he or she currently has.

    a) True
    b) False
    a) True
  12. An investor can compensate for bad investment results in the early years of a retirement portfolio by small reductions in his or her current consumption habits.

    a) True
    b) False
    a) True
  13. Strategic asset allocation decisions are made for the purpose of beating the market.

    a) True
    b) False
    b) False

    It is tactical, not strategic, asset allocation decisions that are made for the purpose of beating the market.
  14. The time of year when a client makes the first investment in a retirement portfolio has no significance.

    a) True
    b) False
    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.
  15. A client who has had some bad returns on his or her retirement portfolio can compensate by increasing the portfolio's risk exposure to obtain higher rates of return.

    a) True
    b) False
    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.
  16. A particularly effective asset allocation strategy is to hold bonds in the tax-qualified accounts and stocks in the nonqualified accounts.

    a) True
    b) False
    b) False

    The problem with this strategy is that it might not produce the asset allocation weights that are considered appropriate for the client.
  17. Under certain conditions, it may make sense to use a tax-qualified account to invest funds for nonretirement purposes.

    a) True
    b) False
    a) True
  18. There is no evidence of uniformity of asset allocation among retirement-oriented mutual funds, even when they have the same retirement date objective.

    a) True
    b) False
    a) True
  19. Making a principal payment on a mortgage is the same as investing one's money at a risk-free rate equal to the mortgage interest rate.

    a) True
    b) False
    a) True
  20. Which of the following combinations best characterizes strategic asset allocation?

    A) a large number of asset categories, precise weights, and analogous to selecting a portfolio on the efficient frontier
    B) a large number of asset categories, a range of weights, and made with the intention to "beat" the market
    C) a few broad asset categories, a range of weights, and analogous to selecting a portfolio on the efficient frontier.
    D) a few broad asset categories, precise weights, and made with the intention to "beat" the market
    C) 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.
    (this multiple choice question has been scrambled)
  21. Which of the following statements should be considered when deciding whether or not to borrow money from a 401(k) plan?

    A) You are always doing harm because the rate of return on this loan to the 401(k) account is less than what you otherwise would have received.
    B) 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.
    C) You can always get an excellent interest rate on this type of loan.
    D) Such loans are always a bad idea.
    B) 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.
    (this multiple choice question has been scrambled)
  22. Which of the following statements regarding younger clients who have a high tolerance for risk and are considering paying down their mortgage is (are) correct?

    I. For younger clients with high risk tolerances who want higher expected returns, this option is not desirable because it is conceptually the same as investing in bonds.

    II. Younger clients would be better off putting what would have been principal payments into more aggressive investments such as stocks and paying off the mortgage by liquidating the stocks at a later date.

    A) II only
    B) I only
    C) Neither I nor II
    D) Both I and II
    D) 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.
    (this multiple choice question has been scrambled)
  23. All the following statements concerning modern portfolio theory are correct EXCEPT

    A) The capital market line is composed of combinations of only two assets: the risk-free asset and the market portfolio.
    B) The capital market line lies beneath the efficient frontier.
    C) The optimal portfolio for a client to hold is determined by the intersection of the capital market line with the highest possible indifference curve.
    D) As a portfolio grows in terms of the number of securities it contains, its risk converges with the risk of the market portfolio.
    B) 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.
    (this multiple choice question has been scrambled)
  24. All the following statements concerning a client’s perception of risk are correct EXCEPT

    A) The more choices a person has regarding investment opportunities, the more likely that person is to invest.
    B) Generally, if the consequences of the decision will be known immediately, the decision maker will be relatively more risk averse than if the consequences of the decision will be unknown for some time.
    C) People may have different degrees of risk tolerance for different investment goals.
    D) Individuals who engage in a risky activity report a greater understanding of the risks involved as well as less fear of them.
    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.
    (this multiple choice question has been scrambled)
  25. All the following statements concerning human capital and its relationship to financial wealth are correct EXCEPT

    A) When a client’s financial assets are small relative to his or her human capital, the degree of diversification among the financial assets is fairly immaterial.
    B) A person’s human capital declines with each year worked.
    C) A high degree of correlation between a client’s human capital and his or her financial assets is a serious problem to be avoided.
    D) A person’s human capital becomes zero on the day of retirement, and his or her wealth typically consists exclusively of his or her financial assets.
    B) 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.
    (this multiple choice question has been scrambled)
  26. Which of the following statements about time diversification is (are) correct?

    I. Because of the benefits of time diversification, people with long time horizons should always invest exclusively in stocks.

    II. The further one is forecasting into the future, the greater the variance of the dollar value of the final portfolio.

    A) Neither I nor II
    B) Both I and II
    C) I only
    D) II only
    D) 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.
    (this multiple choice question has been scrambled)
  27. Which of the following statements is correct regarding modern portfolio theory (MPT)?

    A) MPT makes the assumption that one can identify for each pair of securities the volatility of thereturns for those two securities.
    B) The efficient frontier is constructed using a mathematical tool known as quadratic programming.
    C) If the covariance for two securities is large and negative, the prices of the two securities wouldalmost always move in the same direction.
    D) MPT is based on the premise that all investments may be characterized with two basicnumbers – expected returns and beta of these returns.
    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.
    (this multiple choice question has been scrambled)
  28. All of the following statements are correct regarding modern portfolio theory EXCEPT:

    A) To determine which specific portfolio an investor should hold, one can impose an investor’sindifference curves onto the capital market line.
    B) Typically, the S&P 500 index is used to represent Portfolio M in modern portfolio theory.
    C) The capital market line is a line formed by combinations of the market portfolio and thesecurities market line.
    D) The efficient frontier is the collection of portfolios that can be created which, for any given levelof risk, will provide the maximum expected rate of return.
    C) 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.
    (this multiple choice question has been scrambled)
  29. All of the following statements are correct regarding modern portfolio theory EXCEPT:
    A) Among all portfolios of risky assets, there is a set of efficient portfolios.
    B) A portfolio of stocks can be less risky as a whole than any one of the individual stocks in it.
    C) The risk, return and covariance of assets are important input variables in creating portfolios.
    D) Negatively correlated assets are necessary to reduce the risk of portfolios.
    D) 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.
    (this multiple choice question has been scrambled)
  30. Which of the following statements is/are correct regarding the principles of diversification?

    I. On average, no amount of portfolio diversification can reduce the total risk of a portfolio belowthat of the market portfolio.

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

    A) Only I.
    B) Neither I nor II.
    C) Both I and II.
    D) Only II.
    A) Only I.

    II is incorrect. The optimal portfolio size is inversely related to the magnitude of the commission one pays.
    (this multiple choice question has been scrambled)
  31. Diversification can eliminate which one of the following types of risks?

    A) Non-diversifiable risk.
    B) Systematic risk.
    C) Unsystematic risk.
    D) Market risk.
    C) Unsystematic risk.

    Unsystematic risk is risk that can be reduced or eliminated through diversification.
    (this multiple choice question has been scrambled)
  32. Which of the following statements is correct regarding risk tolerance in given situations?

    A) Investors should generally take on less risk with their retirement portfolio than with portfoliosassociated with other goals.
    B) Individuals are usually willing to take on the most risk when the amount at risk is large.
    C) After an individual overcomes a fear through training, the fear will disappear completely.
    D) If the consequences of a decision will be known soon, the decision maker will be relativelymore risk averse.
    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.
    (this multiple choice question has been scrambled)
  33. Which of the following statements is/are correct regarding risk tolerance?

    I. Clients often have different degrees of risk tolerance for different investment goals.
    II. Studies have shown that the more 401(k) investment choices an individual has, the less likelythe individual is participate in the plan.

    A) Only II.
    B) Both I and II.
    C) Only I.
    D) Neither I nor II.
    D) Neither I nor II.
    (this multiple choice question has been scrambled)
  34. Which of the following statements is correct regarding the concept of the portfolio of assets?

    A) Investors should attempt to minimize the correlation between their human capital and their financial assets.
    B) Human capital refers to an individual’s net worth.
    C) When individuals begin their career, their wealth mostly consists of their financial assets.
    D) A simple way to define an individual’s wealth is to subtract their expenses from their income.
    A) 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.
    (this multiple choice question has been scrambled)
  35. Which of the following statements is correct regarding rates of return?

    A) The greater the standard deviation, the greater the spread between the geometric mean returnand the arithmetic mean return for a given security.
    B) The arithmetic mean rate of return is an appropriate measure of return because it reflects theeffective rate of return over time.
    C) The geometric mean return and the arithmetic mean return for a given security can never beequal.
    D) The geometric mean return calculation has been criticized because it fails to account for thetime value of money.
    A) 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.
    (this multiple choice question has been scrambled)
  36. ABC Corporation stock has an arithmetic mean return of 8% and a standard deviation of 6%. Ifnext year’s return is based on this distribution, there is a 95% probably that the return on this stock willfall within what percentage range?

    a) 6%-8%.
    b) 2%-14%.
    c) (4%)-20%.
    d) 5.7%-7.6%.
    • 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%
  37. All of the following are critical assumptions of Samuelson’s work relating to time diversificationEXCEPT:

    A) Investors will periodically modify their asset allocation based on their time horizon.
    B) Investors have a constant relative risk aversion.
    C) Wealth is limited only to the investment portfolio.
    D) Stock returns in each period are unrelated to the prior period’s returns.
    A) 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.
    (this multiple choice question has been scrambled)
  38. Which of the following statements is/are correct regarding time diversification?

    I. Empirical evidence generally supports the constant relative risk aversion assumption.

    II. The mean reversion process theory states that returns each year are completely independentof the prior year’s returns.

    A) Neither I nor II.
    B) Both I and II.
    C) Only I.
    D) Only II.
    A) 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.
    (this multiple choice question has been scrambled)
  39. Which of the following statements is/are correct regarding time diversification?

    I. Investors with long time horizons until retirement should only consider the riskiest possibleportfolios.

    II. The longer the time horizon, the greater the potential variability of the holding period return.

    A) Neither I nor II.
    B) Only II.
    C) Both I and II.
    D) Only I.
    B) Only II.

    I is incorrect. Investors should consider several portfolios, including those that are not as risky.
    (this multiple choice question has been scrambled)
  40. Which of the following statements is correct regarding strategic asset allocation?

    A. Decisions are normally made with detailed asset sub-categories.
    B. Decisions are made very frequently.
    C. The purpose is to produce an asset allocation that will outperform the market.
    D. A planner following this allocation method may choose index funds for a client.
    D. 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.
    (this multiple choice question has been scrambled)
  41. Which of the following statements is correct regarding tactical asset allocation?

    A. Should be used by a board of trustees to make decisions.
    B. These decisions are made more frequently than strategic asset allocation decisions.
    C. The purpose is to determine the overall risk exposure of the portfolio.
    D. It uses fewer asset categories than strategic asset allocation.
    B. 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.
    (this multiple choice question has been scrambled)
  42. Which of the following statements is correct regarding the characteristics of strategic assetallocation and tactical asset allocation?

    A) Strategic asset allocation decisions are typically made more frequently than tactical assetallocation decisions.
    B) Strategic asset allocation decisions are made for the purpose of beating the market.
    C) Tactical asset allocation decisions typically include many more asset categories than strategic asset allocation decisions.
    D) Financial planners who believe in the efficient market hypothesis are likely to engage in tactical asset allocation decisions.
    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.
    (this multiple choice question has been scrambled)
  43. Which of the following statements is correct regarding the concept of diversification?

    A) The Woerheide-Persson diversification index considers the extent to which stocks in aportfolio are related.
    B) Holding a concentrated portfolio will expose the investor to market risk.
    C) One problem with computing covariance is there is no standard of comparison.
    D) In order to achieve diversification, an investor must hold securities whose correlationcoefficients are high.
    C) 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.
    (this multiple choice question has been scrambled)
  44. Which of the following statements is/are correct regarding taxation of investments?

    I. The traditional tax-efficient asset allocation argument indicates that fixed-income investmentsshould be held in tax-deferred accounts, while equities should be held in taxable accounts.

    II. One of the primary arguments for investing in mutual funds is tax efficiency.

    A) Only II.
    B) Only I.
    C) Neither I nor II.
    D) Both I and II.
    B) Only I.

    II is incorrect. Mutual funds are generally considered tax-inefficient, and this is one of the primaryarguments AGAINST investing in mutual funds.
    (this multiple choice question has been scrambled)
  45. All of the following statements are correct regarding the break-even holding period (BHP)EXCEPT:

    A) BHPs are significantly longer for Roth IRAs than for deductible traditional IRAs.
    B) Higher marginal income tax rates at the time of withdrawal will substantially increase the BHP.
    C) If the actual holding period for an investment is longer than the BHP, the investor would be better off using an IRA.
    D) Higher investment rates of return tend to lengthen the BHP.
    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.
    (this multiple choice question has been scrambled)
  46. Reasons an individual would choose to take out an interest-only mortgage loan include:

    I. They can increase the amount of money available for new investments.

    II. They can afford a bigger house.

    A) Only I.
    B) Only II.
    C) Both I and II.
    D) Neither I nor II.
    C) Both I and II.
    (this multiple choice question has been scrambled)
  47. Which of the following statements is/are correct regarding risk over various planning horizons?

    I. The actual risk associated with “riskier” investments may be less than that associated with“safer” investments when the investment planning horizon is longer term.

    II. For shorter term objectives, bonds or money market instruments may present much less riskthan stocks.

    A) Only II.
    B) Neither I nor II.
    C) Only I.
    D) Both I and II.
    D) Both I and II.
    (this multiple choice question has been scrambled)
  48. Which of the following statements is correct regarding dollar cost averaging?

    A) Dollar cost averaging involves the purchase of a fixed number of shares at specific timeintervals.
    B) Dollar cost averaging is a passive method of investing that can help individuals overcome theirfear of investing.
    C) The disadvantage of dollar cost averaging is that it usually results in a higher average purchase price per share.
    D) Dollar cost averaging will protect the investor against losses in a steadily declining market.
    B) 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.
    (this multiple choice question has been scrambled)
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Module 6
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