NASAA Series 65 — All Questions

According to Modern Portfolio Theory, an efficient portfolio is one that:

• a.Offers the lowest standard deviation of any portfolio available, regardless of the return it is expected to earn
• b.Holds only the single asset with the highest Sharpe ratio, since diversification adds cost without lowering risk
• c.Offers the highest expected return for a given level of risk✓
• d.Has a beta of exactly 1.0, so that it moves in line with the market portfolio

Modern Portfolio Theory, developed by Harry Markowitz, defines an efficient portfolio as one that provides the maximum expected return for a given level of risk, or the least risk for a target return. Such portfolios lie on the efficient frontier. The minimum-variance portfolio is only one point on that frontier, and a beta of 1.0 describes a portfolio that tracks the market, which is not what makes a portfolio efficient. Diversification across imperfectly correlated assets, not a single asset, is what lowers risk for a given return.

Diversification within a portfolio is primarily intended to reduce which type of risk?

• a.Interest rate risk on all bonds
• b.Unsystematic (company-specific) risk✓
• c.Systematic (market) risk
• d.Purchasing power risk

Diversification spreads investments across many securities and sectors to reduce unsystematic risk, which is specific to individual companies or industries. Systematic or market risk affects the entire market and cannot be diversified away. This distinction is fundamental to portfolio construction.

A strategic asset allocation approach is best described as which of the following?

• a.Setting long-term target weights across asset classes and rebalancing to them✓
• b.Shifting weights among asset classes in response to short-term market valuations or economic forecasts
• c.Concentrating in the sector that performed best over the past year and rotating into the next expected leader
• d.Selecting individual securities that appear mispriced and letting the asset class mix result from those choices

Strategic asset allocation establishes long-term target percentages for asset classes based on the investor's goals and risk tolerance, then periodically rebalances back to those targets. Tactical allocation makes shorter-term shifts to exploit perceived opportunities. Rotating into the recent or expected leading sector is a sector-rotation approach. Picking mispriced securities first and letting the asset mix fall out afterwards is bottom-up security selection, which sets no target weights.

When gathering a client profile, which factor is essential to determining suitable recommendations?

• a.The client's current account balance alone, because the size of the account determines which strategies are suitable
• b.The client's past investment returns, because a strategy that worked before should be repeated
• c.The adviser's own market outlook, because the adviser's view decides which products are recommended
• d.The client's investment objectives, time horizon, and risk tolerance✓

Suitable recommendations depend on understanding the client's investment objectives, time horizon and risk tolerance, together with the client's financial situation and liquidity needs. An account balance by itself says nothing about goals or timeline. Past returns do not show what the client needs or can tolerate, and the adviser's market outlook is not a client characteristic, so recommendations built on it ignore the client's circumstances.

A younger investor with a long time horizon and high risk tolerance saving for retirement would most appropriately hold a portfolio weighted toward which of the following?

• a.Growth-oriented equities✓
• b.Fixed annuities with guaranteed rates
• c.Long-term Treasury bonds exclusively
• d.Money market instruments and short-term CDs

A young investor with a long horizon and high risk tolerance can accept short-term volatility in exchange for higher long-term growth, making growth equities appropriate. Time allows recovery from market downturns and lets compounding work. Overly conservative holdings would likely fail to meet long-term retirement goals.

Dollar-cost averaging involves which of the following?

• a.Investing a lump sum all at once to capture the long-run upward drift of the market
• b.Buying a fixed number of shares each period regardless of the price, so the dollars invested vary
• c.Investing a fixed dollar amount at regular intervals regardless of price✓
• d.Adding to a position only when its price falls below the average cost, so the cost basis keeps dropping

Dollar-cost averaging means investing a set dollar amount on a regular schedule, which buys more shares when prices are low and fewer when high and tends to lower the average cost per share over time. Buying a fixed number of shares changes the dollars invested each period, so it is not dollar-cost averaging. A single lump sum has no schedule, and adding only on price declines is averaging down, which depends on price rather than on a fixed schedule. Dollar-cost averaging does not guarantee a profit but imposes discipline.

Which account type generally allows contributions of after-tax dollars with qualified withdrawals being tax-free in retirement?

• a.Traditional IRA
• b.401(k) with pre-tax contributions
• c.SEP IRA
• d.Roth IRA✓

A Roth IRA is funded with after-tax dollars, and qualified withdrawals in retirement, including earnings, are tax-free. Traditional IRAs, standard 401(k)s, and SEP IRAs typically use pre-tax contributions that are taxed upon withdrawal. The Roth's tax-free growth is its defining feature.

Rebalancing a portfolio back to its target allocation after a strong stock rally typically involves which action?

• a.Putting all new contributions into the asset class that rose, so its weight keeps climbing past the target
• b.Selling the underweighted classes and buying more of the rally leader to follow the trend
• c.Waiting until the rally fades before making any trades
• d.Selling some of the appreciated asset class and buying underweighted classes✓

Rebalancing restores target weights by trimming the asset class that has grown beyond its target and adding to those that have fallen below it. This enforces a disciplined 'sell high, buy low' behavior and controls risk. Directing money to the winner, or selling the laggards to buy it, increases concentration and moves the portfolio further from its targets. Waiting for the rally to fade leaves the portfolio overweight, and therefore riskier than intended, in the meantime.

Under current federal rules, long-term capital gains (on assets held more than one year) are generally taxed:

• a.At a higher rate than ordinary income, because the 3.8% net investment income tax applies only to long-term gains
• b.At a flat 28% rate, the same rate that applies to gains on collectibles such as art and coins
• c.At preferential rates lower than ordinary income rates✓
• d.Not at all for any taxpayer, as long as the shares are held in a taxable account for more than one year

Long-term capital gains on assets held more than one year are taxed at preferential rates (generally 0%, 15% or 20%) that are lower than ordinary income tax rates; Internal Revenue Code Section 1(h) caps the tax on net capital gain. Short-term gains, on assets held one year or less, are taxed as ordinary income. The 3.8% net investment income tax applies to both short- and long-term investment income for higher earners and does not raise the long-term rate above the ordinary rate. The 28% rate applies to collectibles gains, not securities, and long-term gains are not tax-free for every taxpayer.26 U.S.C. 1(h)

Tax-loss harvesting is a strategy that involves which of the following?

• a.Selling winners to offset the tax due on unrealized losses
• b.Buying more of a losing position to lower its average cost and claim a deduction for the added shares
• c.Selling securities at a loss to offset realized capital gains✓
• d.Selling a losing position and repurchasing the same security the next day to keep the market exposure

Tax-loss harvesting sells losing positions to realize capital losses that can offset realized capital gains and, up to $3,000 a year, ordinary income. Investors must observe the wash-sale rule, which disallows the loss if substantially identical securities are bought within 30 days before or after the sale, so repurchasing the same security the next day defeats the purpose. Losses on unrealized positions are not deductible, and buying more of a loser creates no loss until a sale occurs. The strategy improves after-tax returns.26 U.S.C. 1091, 1211(b)

The wash-sale rule disallows a tax loss if the investor buys a substantially identical security within what period?

• a.The same trading day only
• b.60 days before the sale only
• c.7 days before or after the sale
• d.30 days before or after the sale✓

The wash-sale rule disallows a capital loss deduction if a substantially identical security is purchased within 30 days before or after the sale, a 61-day window in total. The disallowed loss is added to the cost basis of the replacement shares. This prevents investors from claiming a loss while maintaining the same position.

An investor's asset allocation should shift toward more conservative holdings as which of the following changes?

• a.Their account balance grows substantially, so a larger portfolio can no longer tolerate equity volatility
• b.Stock market valuations rise above their long-run averages, regardless of the investor's own timeline
• c.Interest rates fall to record lows
• d.They approach the time when they will need the funds✓

As an investor nears the point of needing the funds, such as retirement, reducing exposure to volatile assets protects accumulated wealth from a poorly timed downturn, because a shorter time horizon leaves less time to recover from losses. This is the rationale behind glide-path strategies in target-date funds. A larger balance does not by itself change the horizon, and market valuations are not an investor-specific change. Falling interest rates alone are not a reason to move away from growth assets.

The Capital Asset Pricing Model (CAPM) expresses the expected return of a security as a function of which of the following?

• a.The security's standard deviation only, a figure that captures the security's total risk instead of its beta
• b.The risk-free rate plus beta times the market risk premium✓
• c.Only the security's dividend yield
• d.The company's book value alone

CAPM states that a security's expected return equals the risk-free rate plus its beta multiplied by the market risk premium (the market return minus the risk-free rate). It links expected return to systematic risk as measured by beta. Total risk measured by standard deviation is not the CAPM input.

Alpha in portfolio performance measurement represents which of the following?

• a.The portfolio's total volatility as captured by the standard deviation of its periodic returns
• b.The sensitivity of the portfolio's returns to movements in the benchmark index
• c.The portfolio's return in excess of the risk-free rate divided by its standard deviation
• d.The return earned above or below what the portfolio's risk (beta) would predict✓

Alpha measures the return a portfolio earns above or below the return predicted by its beta and the market, indicating value added by management. A positive alpha suggests outperformance on a risk-adjusted basis. Total volatility is captured by standard deviation, sensitivity to the market by beta, and excess return per unit of total risk by the Sharpe ratio.

A client wants current income and capital preservation with low risk. Which allocation is most suitable?

• a.Emerging-market equities and commodities
• b.Long-term zero-coupon bonds and growth stocks, chosen to compound toward the largest possible balance
• c.A mix of high-quality bonds, dividend-paying stocks, and cash equivalents✓
• d.High-yield bonds and master limited partnership units, chosen for their large current income payouts

A client seeking income and capital preservation with low risk is best served by high-quality bonds, dividend-paying blue-chip stocks and cash equivalents. These emphasize stability and steady income. Emerging-market equities and commodities are volatile. Zero-coupon bonds pay no current income and long maturities carry heavy price risk, and high-yield bonds and MLP units pay high income but carry default and price risk that conflicts with capital preservation.

An investment adviser recommending a strategy must ensure it is suitable. Which action best supports suitability?

• a.Recommending the product with the lowest fees available without asking about the client's other holdings, since cost is the only factor that matters
• b.Applying the firm's model portfolio uniformly to every client of the same age, because age alone fixes the right level of risk
• c.Obtaining the client's signature on a disclosure that waives suitability, so the adviser is relieved of responsibility for the recommendation
• d.Documenting the client's objectives, risk tolerance, and financial situation before advising✓

Suitability requires understanding and documenting the client's objectives, risk tolerance, financial situation and needs before making recommendations. Choosing on cost alone, or assigning one portfolio by age, ignores individual circumstances. A client cannot waive an adviser's duties with a signature: as a fiduciary, an adviser owes the client a duty that cannot be disclaimed and must also fully disclose risks and conflicts.

Which retirement plan feature is characteristic of a defined benefit plan?

• a.Contributions are made only by the employee, and the benefit depends on how the employee's chosen investments perform
• b.The employer bears no funding obligation, and the Pension Benefit Guaranty Corporation does not insure the benefit
• c.The employer promises a specified retirement benefit, often based on salary and years of service✓
• d.The employee chooses the investments and bears the risk that the account falls short of retirement needs

A defined benefit plan promises participants a specified retirement benefit, commonly calculated from salary history and years of service, and the employer bears the investment and funding risk. These plans are generally insured by the Pension Benefit Guaranty Corporation. Employee-only contributions, an outcome that depends on the employee's own investment choices, and employee-borne investment risk describe defined contribution plans, where the ultimate benefit depends on contributions and investment performance.

A step-up in cost basis at death generally means which of the following for inherited appreciated securities?

• a.The unrealized gain is taxed to the estate at death as ordinary income
• b.The heir's basis is the lower of the decedent's cost or the market value when the decedent died
• c.The heir's basis is adjusted to the fair market value on the date of death✓
• d.The heir takes the decedent's original cost as basis, the same carryover treatment that applies to a lifetime gift

When appreciated securities pass to an heir, the basis is generally stepped up to the fair market value on the date of death (or the alternate valuation date), potentially eliminating the built-in capital gain. If the heir later sells near that value, little or no gain is recognized. The gain is not taxed to the estate at death, and carryover basis applies to lifetime gifts, not inherited property. The lower-of-cost-or-value rule is the dual-basis rule for gifts sold at a loss.26 U.S.C. 1014(a)

An efficient frontier graph plots portfolios according to which two dimensions?

• a.Liquidity and after-tax return of each holding
• b.Expected return and risk (standard deviation)✓
• c.Required return and systematic risk (beta), as on the security market line
• d.Dividend yield and price-to-earnings ratio of each security

The efficient frontier plots portfolios by expected return on one axis and risk, measured by standard deviation, on the other. Portfolios on the frontier offer the maximum return for a given level of risk. Points below the frontier are inefficient because a better trade-off is available. Plotting required return against beta describes the security market line, a different graph, and liquidity, tax efficiency, yield and price-to-earnings are not the two axes.

A client in a high tax bracket seeking tax-advantaged income would most likely benefit from which of the following?

• a.High-yield corporate bonds
• b.Municipal bonds✓
• c.Certificates of deposit
• d.Money market funds

Municipal bond interest is generally exempt from federal income tax, making munis especially valuable to investors in high tax brackets on an after-tax basis. Corporate bonds, CDs, and money market funds generate fully taxable interest. Advisers compare yields on a taxable-equivalent basis to confirm the benefit.

A bond ladder strategy is designed primarily to accomplish which of the following?

• a.Place the entire portfolio in the longest maturity available to capture the highest yield on the yield curve
• b.Hold bonds only at the very short and very long ends of the maturity range, with none in the middle
• c.Time the market by buying each rung only after interest rates have peaked and prices have bottomed
• d.Spread maturities over time to manage interest rate and reinvestment risk✓

A bond ladder staggers maturities across several dates so that portions of the portfolio mature and can be reinvested at regular intervals. This smooths reinvestment risk and reduces sensitivity to any single interest rate environment, and it provides periodic liquidity. Concentrating in the longest maturity is a bullet approach with heavy interest rate risk, holding only short and long maturities is a barbell, and a ladder does not depend on predicting rate peaks.

Which statement about a 529 college savings plan is accurate?

• a.Earnings grow tax-deferred and qualified education withdrawals are tax-free✓
• b.The account owner must be the student beneficiary, so a parent or grandparent cannot own the plan
• c.Funds can be withdrawn tax-free for any purpose
• d.Contributions are deductible on the federal return up to the annual gift tax exclusion amount

A 529 plan allows investments to grow tax-deferred, and withdrawals used for qualified education expenses are free from federal income tax. The owner does not have to be the beneficiary, since a parent or grandparent commonly owns the account. Contributions are not federally deductible; they are treated as completed gifts, and some states offer a state tax benefit. Non-qualified withdrawals of earnings are taxed and may incur a penalty.26 U.S.C. 529

An investor holds a portfolio of 30 stocks across many industries. Which risk remains that cannot be diversified away?

• a.Systematic (market) risk✓
• b.Business risk of one company
• c.Default risk of a single issuer
• d.Industry-specific risk

Broad diversification across many companies and industries reduces unsystematic risks such as business, industry, and single-issuer default risk. However, systematic or market risk, arising from factors affecting the entire market like recessions or interest rate shifts, cannot be diversified away. This residual risk is measured by beta.

A required minimum distribution (RMD) generally applies to which type of account?

• a.A Roth IRA during the original owner's lifetime
• b.A traditional IRA once the owner reaches the applicable age✓
• c.A 529 education savings plan
• d.A taxable brokerage account

Traditional IRAs and similar pre-tax retirement accounts require minimum distributions beginning at the age set by law, ensuring the deferred amounts are eventually taxed. Roth IRAs are not subject to RMDs during the original owner's lifetime. Taxable brokerage and 529 accounts have no RMD requirement.

An adviser evaluating two portfolios with equal returns should generally prefer the one with which characteristic?

• a.The lower standard deviation✓
• b.The higher beta
• c.The lower correlation to Treasury bills
• d.The higher standard deviation

When two portfolios offer the same expected return, the one with lower standard deviation carries less risk and is therefore more efficient. Rational, risk-averse investors prefer less volatility for the same reward. This risk-adjusted thinking underlies measures like the Sharpe ratio.

The present value of a future stream of retirement income needs is most affected by which assumption?

• a.The number of accounts the client holds, because each account must be discounted separately at its own rate
• b.The assumed inflation and discount rate applied to future cash needs✓
• c.The client's current salary only, because the present value of income needs always equals one year of pay
• d.The historical average return of the stock market over the past decade, rather than assumptions about future inflation and discounting

Retirement income planning discounts future spending needs to present value, and the assumed inflation and discount rates strongly influence how much must be saved today. Higher inflation raises future needs, while a higher discount rate lowers present value. The number of accounts does not change the total needed, a single year of pay is not the present value of a stream of needs, and past market returns are not the assumptions that drive the calculation.

Which order type guarantees execution but not price?

• a.A buy limit order
• b.A limit order
• c.A stop-limit order
• d.A market order✓

A market order is executed promptly at the best available price, guaranteeing execution but not a specific price. A limit order guarantees the price or better but may not execute. Stop-limit orders combine a trigger with a limit and likewise are not guaranteed to fill.

A sector rotation strategy involves which of the following?

• a.Holding a fixed, unchanging allocation forever
• b.Rebalancing back to fixed long-term asset class targets on a set schedule regardless of the economic cycle
• c.Shifting investments among industry sectors based on the economic cycle✓
• d.Moving from stocks into bonds on a fixed schedule as the investor ages, with no view on industry sectors

Sector rotation shifts portfolio emphasis among industry sectors expected to outperform at different stages of the business cycle, such as favoring cyclicals in expansions and defensives in downturns. It is an active, tactical approach. A fixed allocation held forever is buy-and-hold, rebalancing to set targets regardless of the cycle is strategic allocation, and an age-based shift from stocks to bonds is a glide path.

A durable power of attorney is an estate planning tool that does which of the following?

• a.Allows a designated agent to act on someone's behalf, remaining effective if they become incapacitated✓
• b.Remains effective after the principal's death until the estate is settled
• c.Takes effect only if the principal becomes incapacitated, and ends when he or she recovers
• d.Transfers the principal's assets to named heirs at death without probate

A durable power of attorney authorizes a designated agent to make financial or other decisions on the principal's behalf and, unlike an ordinary power of attorney, remains valid if the principal becomes incapacitated. It ends at the principal's death, so it does not continue to settle the estate. A springing power is one that begins only on incapacity, which is a variation rather than the defining feature of a durable power. Passing assets to heirs is the job of a will, a trust or beneficiary designations, and a power of attorney has no direct effect on estate taxes.

A revocable living trust offers which primary benefit during the grantor's lifetime and at death?

• a.Assets are removed from the grantor's taxable estate, so no federal estate tax is owed at the grantor's death
• b.Income is taxed to the trust rather than the grantor, so the grantor owes less income tax each year
• c.It guarantees a fixed investment return
• d.Assets can avoid probate while the grantor retains control during life✓

A revocable living trust lets the grantor retain control and amend or revoke the trust during life, and assets held in it generally pass to beneficiaries outside of probate at death. Because the trust is revocable, its assets remain part of the grantor's taxable estate and its income is taxed to the grantor, so it provides no estate or income tax shelter. It also guarantees no investment return. Its main advantages are probate avoidance and continuity of management.

When measuring investment performance, time-weighted return is preferred over dollar-weighted return when the goal is to:

• a.Account for the size of external cash flows
• b.Evaluate the performance of the portfolio manager independent of client cash flows✓
• c.Show the client's personal gain after taxes and fees, including the effect of when the client added or withdrew money
• d.Calculate the growth rate that equates the account's beginning value and all cash flows to its ending value

Time-weighted return removes the distorting effect of client deposits and withdrawals, isolating the manager's investment performance for fair comparison. Dollar-weighted return, or internal rate of return, equates the beginning value and all cash flows to the ending value and so reflects the timing of cash flows, which makes it better for measuring the investor's actual experience. Accounting for the size of external cash flows or the client's personal after-tax result therefore points to the dollar-weighted measure.

A client nearing retirement expresses a low risk tolerance but wants growth to keep pace with inflation. The most balanced recommendation is:

• a.Place 100% of assets in aggressive growth stocks to maximize the chance of outpacing inflation over the next 30 years
• b.Hold long-term Treasury bonds exclusively, because their guaranteed coupons remove any need for growth in the portfolio
• c.Move everything to cash and money market funds, accepting that purchasing power will erode but principal stays stable
• d.Blend high-quality bonds and dividend equities to balance stability with modest growth✓

A near-retiree with low risk tolerance but a need to outpace inflation is best served by a balanced mix of high-quality bonds for stability and dividend-paying equities for modest growth and inflation protection. All-equity exceeds the stated risk tolerance, all long-term bonds carry heavy interest rate risk and fixed coupons that lose purchasing power, and all-cash erodes purchasing power. Balancing competing objectives is central to suitable advice.

A portfolio's expected return is calculated as which of the following?

• a.The simple average of the holdings' expected returns, giving every holding the same weight regardless of its size
• b.The return of the benchmark index minus fees
• c.The highest expected return among its holdings, reduced by the portfolio's standard deviation
• d.The weighted average of the expected returns of its individual holdings✓

A portfolio's expected return is the weighted average of the expected returns of its component assets, with weights equal to each asset's proportion of the portfolio. A simple average ignores position sizes, and neither the best single holding nor a benchmark return less fees is the portfolio's own expected return. Unlike return, portfolio risk depends on correlations and is not simply a weighted average of individual risks.

The semi-strong form of the Efficient Market Hypothesis (EMH) holds that security prices fully reflect:

• a.Only past price and trading-volume data, so technical analysis cannot earn excess returns but fundamental analysis of public data can
• b.All public and private information, so that not even insiders trading on confidential data can earn excess returns
• c.Prices adjust to new information slowly over several months, so investors acting on public news can consistently earn excess returns
• d.All publicly available information, so analysis of public data cannot consistently produce excess returns✓

The semi-strong form of the EMH holds that prices already reflect all public information, implying that fundamental analysis of public data cannot reliably beat the market. The weak form covers only past prices and volume, which would undermine technical analysis but still leave room for fundamental analysis, and the strong form adds private or inside information. A view that prices adjust slowly to news is a rejection of market efficiency, not a form of it.

Compared with active management, passive (index) management generally offers:

• a.Frequent security selection to exploit perceived mispricing
• b.Higher portfolio turnover and higher costs than active management
• c.A guarantee of beating the benchmark
• d.Lower costs, lower turnover, and greater tax efficiency, with returns that track a benchmark✓

Passive (index) management seeks to match a benchmark at low cost, producing low turnover and greater tax efficiency. Higher turnover, higher costs, and active security selection describe active management, the traps in the first and last options. No strategy can guarantee outperformance.

A value investing style typically favors stocks that:

• a.Are chosen solely by their beta
• b.Pay no dividends and reinvest all earnings
• c.Have high price-to-earnings and price-to-book ratios with rapid earnings growth
• d.Trade at low price-to-earnings or price-to-book ratios relative to fundamentals and appear underpriced✓

A value style favors stocks trading at low price-to-earnings or price-to-book ratios relative to their fundamentals, on the view that they are underpriced, and such stocks often pay higher dividends. High multiples with rapid growth and little or no dividend describe a growth style, which is the trap in the first and third options.

An investor who owns 100 shares of a stock and sells (writes) one call option against those shares has established a:

• a.Covered call, earning premium income while capping gains above the strike✓
• b.Protective put
• c.Long straddle
• d.Naked call carrying unlimited risk

Owning 100 shares and writing one call against them is a covered call: the premium adds income and a small downside cushion, but upside is capped at the strike price. Because the shares are owned, the written call is covered, not naked, which is the trap that would carry unlimited risk. A protective put involves buying, not selling, an option.

An investor holding a long stock position buys a put option on that stock. The primary purpose is to:

• a.Obligate the investor to buy more shares at the strike price if the stock falls, which lowers the average cost of the position
• b.Set a floor selling price for the stock, functioning like insurance against a decline✓
• c.Profit if the stock rises by more than the premium, because the put gains value as the price of the stock increases
• d.Earn extra income from the option premium while agreeing to sell the stock at the strike price if it is called away

Buying a put on stock already owned is a protective put: the put's right to sell at the strike sets a price floor, limiting downside much like insurance, at the cost of the premium paid. A put buyer has a right, never an obligation, to trade, so the buyer is not forced to buy more shares. A put loses value as the stock rises, and earning premium income while accepting a sale at the strike describes writing a covered call, not buying a put.

Qualified dividends received by an individual investor are generally taxed at:

• a.Ordinary income tax rates, the same as interest from a bank account or corporate bond, whatever the holding period
• b.A flat 15% rate for every taxpayer, whatever the holding period or the investor's taxable income
• c.The long-term capital gains rate only if the dividends are automatically reinvested; cash dividends are taxed at ordinary rates
• d.The lower long-term capital gains rates, provided holding-period requirements are met✓

Qualified dividends are ordinary dividends that qualify to be taxed at the lower long-term capital gains rates, provided the holding-period requirements are met. Non-qualified dividends are instead taxed at ordinary income rates, interest-like treatment that is the trap in the first option. The favorable rate does not depend on reinvesting the dividend, and it is not one flat rate for everyone, because the capital gains rates step up with taxable income.

The federal annual gift tax exclusion allows an individual to:

• a.Give up to an inflation-adjusted amount per recipient each year without using the lifetime exemption or filing a gift tax return✓
• b.Give a fixed $10,000 to each recipient every year, a statutory amount that is never adjusted for inflation, without using any lifetime exemption
• c.Give up to the lifetime exemption amount to any one recipient in a single calendar year without filing a gift tax return or owing any gift tax
• d.Deduct gifts up to the annual exclusion amount on the donor's income tax return, with larger gifts carried forward to later tax years

The annual gift tax exclusion lets a donor give up to a set, inflation-indexed amount per recipient each year with no gift tax, no gift tax return, and no reduction of the lifetime exemption. The statute started at $10,000 per recipient but has been adjusted for inflation since 1998, so a fixed $10,000 is out of date. The lifetime exemption is a separate, much larger amount that a return is needed to use, and gifts are not deductible from income tax.Internal Revenue Code Section 2503(b) (26 U.S.C. 2503(b))

Under ERISA, a fiduciary managing a qualified retirement plan must invest plan assets in accordance with which standard?

• a.The prudent-man rule of state trust law, under which a trustee may invest only in a list of securities approved by the state
• b.The safe-harbor rule, under which plan assets may be held only in guaranteed insurance contracts and Treasury securities to avoid any loss
• c.The business judgment of the plan sponsor, so plan assets may be invested in the employer's own stock whenever that supports the company's share price
• d.The prudent-expert rule, acting solely in participants' interest and diversifying to minimize the risk of large losses✓

ERISA Section 404(a)(1) holds plan fiduciaries to a prudent-expert standard: they must act solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits, with the care, skill and diligence of a prudent person familiar with such matters, and must diversify investments to minimize the risk of large losses unless it is clearly prudent not to. A state legal-list rule is not the ERISA standard, nothing in ERISA confines plan assets to guaranteed products, and serving the sponsor's share price over participants' interests would breach the duty of loyalty.ERISA Section 404(a)(1) (29 U.S.C. 1104(a)(1))

A bond portfolio immunization strategy seeks to:

• a.Match the portfolio's duration to the investor's time horizon so that price and reinvestment risks offset✓
• b.Spread bond maturities evenly across short, intermediate and long terms so that a rate change affects only part of the portfolio at a time
• c.Eliminate credit and default risk by holding only the highest-rated government and agency bonds, whatever their duration
• d.Increase the portfolio's duration whenever the investor expects interest rates to fall, to maximize short-term trading gains

Immunization matches a bond portfolio's duration to the investor's time horizon so that a rate change's effect on price is offset by its opposite effect on reinvestment income, locking in a target return. Spreading maturities evenly is a ladder, which dilutes rate risk without matching duration to a horizon. Holding only government bonds addresses credit risk, not interest-rate risk, and lengthening duration on a rate forecast is an active bet that immunization is designed to avoid.

The Treynor ratio measures a portfolio's excess return per unit of:

• a.Total risk, using standard deviation
• b.Unsystematic (company-specific) risk only
• c.Liquidity risk
• d.Systematic risk, using beta✓

The Treynor ratio divides a portfolio's excess return by its beta, measuring reward per unit of systematic (market) risk. The Sharpe ratio instead uses standard deviation, measuring reward per unit of total risk, which is the trap in the second option. The two ratios differ only in the risk measure used in the denominator.

Dollar-weighted return (internal rate of return) is most appropriate when an analyst wants to measure:

• a.The portfolio manager's performance independent of client cash-flow timing
• b.The return calculated with all dividends ignored
• c.Only the benchmark index's return
• d.The investor's actual return, reflecting the timing and size of cash flows into and out of the account✓

Dollar-weighted return, the internal rate of return, accounts for the timing and size of deposits and withdrawals, capturing the investor's actual experience. Time-weighted return removes cash-flow effects to isolate the manager's skill, which is the trap in the first option. The choice depends on whether you are judging the investor's result or the manager's.

A portfolio has an expected return of 10% and a standard deviation of 15%, with returns normally distributed. Approximately 68% of outcomes are expected to fall within which range?

• a.Between -20% and 40%
• b.Between 0% and 10%
• c.Between 10% and 15%
• d.Between -5% and 25%✓

About 68% of outcomes lie within one standard deviation of the mean: 10% plus or minus 15%, giving -5% to 25%. Roughly 95% fall within two standard deviations, -20% to 40%, which is the trap.

A portfolio holds 60% in a stock fund with an expected return of 12% and 40% in a bond fund with an expected return of 5%. The portfolio's expected return is:

• a.17%
• b.8.5%
• c.9.2%✓
• d.6.8%

A portfolio's expected return is the weighted average of its holdings: (0.60 times 12%) plus (0.40 times 5%) equals 7.2% plus 2.0%, or 9.2%. Adding the two returns without weighting gives the 17% trap.

When two risky assets are combined, the portfolio's standard deviation is minimized when the assets have:

• a.Identical expected returns
• b.The lowest possible correlation with each other✓
• c.A correlation of +1.0
• d.A beta of exactly 1.0 each

The lower, or more negative, the correlation between assets, the greater the risk reduction from diversification; a correlation of +1.0 provides none. Portfolio risk is not a simple weighted average precisely because of correlation effects.

A portfolio is invested 50% in a stock with a beta of 1.4 and 50% in a stock with a beta of 0.6. The portfolio beta is:

• a.0.8
• b.1.0✓
• c.2.0
• d.1.4

Portfolio beta is the weighted average of component betas: (0.50 times 1.4) plus (0.50 times 0.6) equals 0.70 plus 0.30, or 1.0, meaning the portfolio should move roughly in line with the market. Summing the betas gives the 2.0 trap.

Using CAPM, a stock with a beta of 1.2 when the risk-free rate is 3% and the expected market return is 9% has an expected return of:

• a.7.2%
• b.12%
• c.10.2%✓
• d.9%

CAPM gives expected return equal to the risk-free rate plus beta times the market risk premium: 3% plus 1.2 times (9% minus 3%) equals 3% plus 7.2%, or 10.2%. The market risk premium here is 6%.

A portfolio returns 12% with a standard deviation of 20% when the risk-free rate is 2%. Its Sharpe ratio is:

• a.0.50✓
• b.0.10
• c.6.0
• d.0.60

The Sharpe ratio equals excess return divided by standard deviation: (12% minus 2%) divided by 20% equals 10 divided by 20, or 0.50. It measures reward per unit of total risk. Forgetting to subtract the risk-free rate gives 0.60.