NASAA Series 65 — All Questions

A call option with a strike price of $50 is held while the underlying stock trades at $55. The option's intrinsic value is:

• a.$55
• b.$0
• c.$50
• d.$5✓

A call's intrinsic value equals the stock price minus the strike when positive: $55 minus $50 equals $5, so the call is in the money. Any premium above $5 represents time value, not intrinsic value.

An investor buys a call with a $50 strike for a premium of $3. The breakeven price of the underlying at expiration is:

• a.$50
• b.$53✓
• c.$3
• d.$47

Breakeven for a long call equals the strike price plus the premium paid: $50 plus $3 equals $53. The stock must rise above breakeven for the buyer to profit, and the maximum loss is the $3 premium.

Rights of accumulation in a mutual fund allow an investor to:

• a.Count the current value of existing holdings toward reaching a breakpoint on new purchases✓
• b.Commit in writing to invest a stated amount within 13 months to earn a reduced sales charge
• c.Exchange shares of one fund for shares of another fund in the same family without paying a new sales charge
• d.Reinvest dividends and capital gains distributions in additional shares without paying a sales charge

Rights of accumulation let an investor qualify for a reduced sales charge by adding the value of prior holdings to new investments to reach a breakpoint. Unlike a letter of intent, they need not be pledged in advance. A written commitment to invest a stated amount over a period is a letter of intent, exchanging among funds in a family is a conversion (exchange) privilege, and sales-charge-free reinvestment of distributions is the reinvestment privilege.

Which characteristic applies to a U.S. Treasury bill?

• a.Its interest is exempt from federal income tax but subject to state and local income tax
• b.It is issued at par, matures in 30 years, and pays a fixed coupon every six months
• c.It is issued at a discount, matures in one year or less, and pays no periodic interest✓
• d.Its principal adjusts with the CPI and it pays a fixed rate of interest on the adjusted principal

T-bills mature in one year or less and are sold at a discount, returning par at maturity with no coupons. Like all Treasuries, their interest is federally taxable but exempt from state and local tax, so the reversed tax statement is the trap. A 30-year maturity with semiannual coupons describes a Treasury bond, and CPI-adjusted principal describes TIPS.

An equipment trust certificate is a debt security that is:

• a.Secured by a first mortgage on the real estate that the issuer owns
• b.Secured by specific physical equipment such as aircraft or railcars owned by the issuer✓
• c.Secured by securities of other companies that the issuer deposits with a trustee
• d.Backed only by the issuer's general credit, ranking behind all secured creditors in a liquidation

An equipment trust certificate is secured by title to specific equipment and is commonly issued by transportation companies, making it a secured bond. A mortgage bond pledges real property, a collateral trust bond pledges securities held by a trustee, and a debenture is backed only by general credit, which is the unsecured trap.

In a corporate liquidation, a subordinated debenture is paid:

• a.After other general creditors and senior debt, but before preferred and common stockholders✓
• b.Ahead of secured bondholders and senior debt, since subordinated status gives holders a first-priority claim
• c.After preferred stockholders but before common stockholders
• d.Pro rata with common stockholders once all senior and general creditors are paid

Subordinated debt ranks below senior debt and general creditors but still ahead of equity holders. The liquidation priority runs secured creditors, then senior debt, then general creditors, then subordinated debt, then preferred, then common stock. Subordination lowers a claim rather than raising it, and being a creditor, a subordinated debenture holder is paid before any preferred or common stockholder, not alongside them.

A closed-end fund whose shares trade at a market price above net asset value is said to trade at:

• a.A discount
• b.Its redemption value
• c.A premium✓
• d.Par value

Closed-end fund shares trade on an exchange at supply-and-demand prices that can exceed NAV (a premium) or fall below it (a discount). Only open-end fund shares always transact at NAV, so the redemption-value option is the trap.

For a callable bond trading at a premium, the yield figure that assumes the bond is redeemed at the first call date is the:

• a.Current yield
• b.Nominal yield
• c.Tax-equivalent yield
• d.Yield to call✓

Yield to call computes the return if the bond is redeemed at the call date and call price. For a premium callable bond, the yield to call is typically lower than the yield to maturity, and the more conservative of the two is quoted as the yield to worst.

A Series I savings bond issued by the U.S. Treasury earns a return based on:

• a.A fixed rate set at purchase, with the Treasury guaranteeing the bond will double in value in 20 years
• b.A variable rate tied to the prevailing yield on Treasury bills, reset every six months
• c.A combination of a fixed rate and an inflation rate that adjusts with the CPI✓
• d.The inflation rate alone, adjusted every six months, with no fixed rate component

Series I savings bonds pay a composite rate combining a fixed rate, constant for the life of the bond, and a semiannually adjusted inflation rate tied to the CPI, protecting purchasing power. A 20-year doubling guarantee describes Series EE bonds, and a rate that follows Treasury bill yields is not how I bonds work. The fixed component is part of the composite, so the inflation rate alone is incomplete. Interest is state-tax exempt and federally deferrable until redemption.

A key difference between an exchange-traded fund (ETF) and a traditional open-end mutual fund is that an ETF:

• a.Trades intraday on an exchange at market-determined prices and can be sold short or bought on margin✓
• b.Always trades at exactly its net asset value, since authorized participants keep the price aligned
• c.Must be actively managed, since index tracking is permitted only for open-end mutual funds
• d.Is sold by the fund directly to individual investors at the next-calculated net asset value

ETFs trade throughout the day at market prices and, like stocks, can be margined or sold short, whereas open-end mutual fund shares transact only at end-of-day NAV. Arbitrage by authorized participants keeps an ETF's price close to NAV but does not guarantee it, and ETFs can trade at a premium or discount. Many ETFs are designed specifically to track an index, and individual investors buy and sell them in the market rather than from the fund.

Unlike a fixed annuity, a variable annuity is:

• a.Guaranteed by the insurer's general account against any loss of principal
• b.Regulated only by state insurance departments, since it is sold by licensed insurance agents
• c.Regulated as a security requiring a prospectus, because the owner bears the investment risk of the separate account✓
• d.Guaranteed a minimum return, with the insurer bearing all of the investment risk

A variable annuity's value fluctuates with separate-account subaccounts, placing investment risk on the owner, so it is a security requiring registration and prospectus delivery, and selling it requires securities registration. A fixed annuity shifts risk to the insurer and is not a security. A variable annuity does not guarantee principal or a minimum return, and it is not regulated by insurance departments alone.

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.

CAPM indicates a stock's required return is 10%, but an analyst's research projects it will actually return 12%. According to this analysis, the stock is:

• a.Fairly valued, since analyst projections and CAPM estimates both fall within normal error
• b.Overvalued, since it plots below the security market line and its holders should sell
• c.Undervalued, since its expected return exceeds the return required for its risk✓
• d.More volatile than the market, since a 12% return implies a beta greater than 1.0

When a security's expected return exceeds its CAPM-required return, it plots above the security market line and is considered undervalued, a buy. A stock plotting below the line, with expected return under the required return, would be overvalued. A 2-point gap is not noise to be dismissed, and beta is an input to the required return, not something inferred from an analyst's return forecast.

An investor holding long-term fixed-rate bonds is most exposed to purchasing-power (inflation) risk, which is the danger that:

• a.Rising interest rates will push the market price of the bonds below what the investor paid
• b.Rising inflation will erode the real value of the bonds' fixed interest payments✓
• c.Falling interest rates will force the investor to reinvest the coupons at lower yields
• d.The issuer's credit rating will be cut, lowering the market value of the bonds it has issued

Purchasing-power (inflation) risk is greatest for long-term fixed-income holdings because inflation erodes the real value of fixed coupons and principal. A price decline from rising rates is interest-rate risk, reinvesting at lower yields is reinvestment risk, and a downgrade is credit risk. Each is a separate concept.

Reinvestment risk is the risk that:

• a.Inflation will erode the real value of the interest and principal the investor receives
• b.A bond's market price will fall when interest rates rise, producing a loss if the bond is sold before maturity
• c.Interest and principal received must be reinvested at lower prevailing rates when rates have fallen✓
• d.A bond issuer will default on its coupon payments, leaving the investor unable to collect interest owed

Reinvestment risk arises when cash flows such as coupons or maturing principal must be reinvested at lower rates after rates decline. A zero-coupon bond held to maturity avoids coupon reinvestment risk. Price falling as rates rise is interest-rate risk, the loss of real value is purchasing-power risk, and nonpayment is default (credit) risk.

Liquidity risk refers to the possibility that an investor:

• a.Must reinvest coupons and maturing principal at lower yields after rates decline
• b.Faces a rating downgrade that widens the yield spread the market demands on the issuer's bonds
• c.Cannot sell an asset quickly without accepting a significant price concession✓
• d.Sees a bond's price fall because market interest rates have risen since the bond was issued

Liquidity, or marketability, risk is the danger of not being able to convert an asset to cash promptly at a fair price. Thinly traded securities such as some limited partnerships carry high liquidity risk. Reinvesting at lower yields is reinvestment risk, a downgrade is credit risk, and a price decline from rising rates is interest-rate risk.

A U.S. investor who buys the stock of a foreign company faces currency (exchange-rate) risk, meaning returns can be reduced if:

• a.The foreign company raises its dividend
• b.The foreign currency strengthens against the U.S. dollar
• c.The foreign currency weakens against the U.S. dollar✓
• d.U.S. inflation falls

For a U.S. investor, gains on foreign holdings shrink when the foreign currency depreciates against the dollar, because the same foreign-currency proceeds convert to fewer dollars. A strengthening foreign currency would enhance returns.

The risk that a change in tax law or government regulation will adversely affect an investment is known as:

• a.Credit risk
• b.Legislative (political/regulatory) risk✓
• c.Market risk
• d.Reinvestment risk

Legislative or political risk is the danger that new laws, taxes, or regulations impair an investment's value, such as removing a tax exemption. It is distinct from market, credit, and reinvestment risk.

Financial risk, as distinct from business risk, refers primarily to the danger that:

• a.A company's use of debt (leverage) impairs its ability to meet fixed obligations✓
• b.Weak demand or rising operating costs reduce the company's sales and operating profits
• c.Poor management decisions erode the company's competitive position within its industry
• d.A change in the general level of interest rates lowers the market value of the company's bonds

Financial risk stems from a firm's leverage, how heavily it relies on borrowed money and its ability to service that debt. Business risk relates to operations, competition, management quality and demand, which are the traps. A change in market interest rates affects bond prices generally and is interest-rate risk, not the firm's financial risk.

An investor holds a broadly diversified portfolio of 50 stocks across many sectors. The risk that remains and cannot be diversified away is:

• a.The default risk of a single issuer
• b.Industry-specific risk
• c.The business risk of one company
• d.Systematic (market) risk, measured by beta✓

Diversification eliminates most unsystematic risk, which is company- and industry-specific, but systematic (market) risk, driven by economy-wide factors like recessions or rate changes, remains and is measured by beta.

Under a constant-dollar investment plan, the investor:

• a.Keeps a fixed dollar amount in the aggressive portion, selling after gains and buying after declines to restore that amount✓
• b.Maintains a fixed percentage in stocks at all times
• c.Invests a fixed dollar amount of new money each month regardless of price, buying more shares when prices fall and fewer when prices rise to lower the average cost per share
• d.Buys only when the market reaches new highs

A constant-dollar plan holds a set dollar amount in the aggressive portion; when stocks rise above that level the investor sells, and when they fall below it the investor buys, enforcing sell-high, buy-low discipline. Investing fixed new money each period is dollar-cost averaging, the trap.

A constant-ratio plan differs from a constant-dollar plan because it:

• a.Maintains a fixed percentage allocation between the aggressive and defensive portions, rebalancing back to those ratios✓
• b.Holds a fixed dollar amount in the aggressive portion, selling or buying the rest as markets move
• c.Buys a fixed dollar amount of the same security at regular intervals regardless of price
• d.Changes the aggressive-to-defensive ratio as market levels change, reducing equities as prices rise

A constant-ratio plan keeps a set percentage mix, such as 60/40, and rebalances back to it as markets move. Holding a fixed dollar amount in the aggressive portion is the constant-dollar plan it is being contrasted with, buying a fixed dollar amount at regular intervals is dollar-cost averaging, and changing the ratio as the market moves is a variable-ratio plan.

One advantage of a long-term buy-and-hold strategy over frequent trading is that it:

• a.Removes the need to diversify, because a long holding period smooths out the volatility of any one security
• b.Converts all gains to tax-free income once the securities have been held beyond the first year
• c.Defers capital gains taxes and reduces transaction costs, improving after-tax returns✓
• d.Guarantees a higher pre-tax return than active trading in every market environment

Buy-and-hold postpones realizing capital gains, which defers the tax, and it keeps commissions and turnover low, so after-tax, net-of-cost returns improve. A long holding period does not remove the need to diversify, does not make gains tax-free (long-term gains are still taxed, at preferential rates), and does not guarantee that buy-and-hold beats active trading in every market.

An investor selling part of a position in a taxable account can generally minimize the current tax, absent instruction, by using which cost-basis method?

• a.Average cost, which is required for individual stocks
• b.Specific identification of the highest-cost shares, if properly identified at the time of sale✓
• c.First-in, first-out in every case, which the IRS mandates for all stock and does not permit any other basis method to be elected by the taxpayer
• d.Selling the lowest-cost shares to maximize the reported gain

By specifically identifying and selling the highest-cost lots, an investor realizes the smallest gain and lowest current tax. Absent identification, the IRS default for stock is FIFO, which usually sells the oldest, lowest-cost shares first and produces a larger gain.

When appreciated securities are given as a gift during the donor's lifetime, the recipient's cost basis for calculating a later gain is generally:

• a.Zero
• b.The fair market value on the date of the gift
• c.The donor's original cost basis (carryover basis)✓
• d.Stepped up to fair market value, eliminating the gain

Gifted securities generally carry over the donor's cost basis for computing a future gain, unlike inherited securities, which receive a stepped-up basis to date-of-death value. The gift-carryover versus inheritance-step-up distinction is frequently tested.

Interest on certain private-activity municipal bonds, though exempt from regular federal income tax, may be:

• a.A preference item includible when computing the alternative minimum tax (AMT)✓
• b.Taxable as ordinary income whenever the investor's bracket is 24% or higher
• c.Exempt from federal tax but taxable by the issuing state, even for that state's own residents
• d.Reported as long-term capital gain in the year received, taxed at 0%, 15%, or 20%

Interest on specified private-activity bonds is a preference item for the alternative minimum tax (IRC 57(a)(5)), so an investor subject to AMT may owe tax on interest that is otherwise exempt from regular federal income tax. It is not taxed as ordinary income merely because the investor is in a high bracket, it is not capital gain, and it is not made taxable by the issuing state for that state's own residents. Public-purpose general obligation bonds are not AMT preference items.26 U.S.C. 57(a)(5) (tax-exempt interest on specified private activity bonds, AMT preference)

An investor sells a stock at a loss on December 1 and repurchases the same stock on December 20. Under the wash-sale rule:

• a.The loss is disallowed and added to the cost basis of the repurchased shares✓
• b.The loss is fully deductible immediately
• c.The investor must pay a separate penalty tax equal to a fixed percentage of the disallowed loss for the year
• d.The loss is converted into a long-term gain

Buying a substantially identical security within 30 days before or after a loss sale triggers the wash-sale rule: the loss is disallowed and added to the replacement shares' basis. Here the repurchase is 19 days later, inside the 30-day window.

The kiddie tax generally causes a minor child's unearned investment income above an annual threshold to be:

• a.Taxed at the child's zero bracket without any limit
• b.Taxed at the parents' (higher) marginal tax rate✓
• c.Exempt from all federal income tax
• d.Deductible by the parents on their return

The kiddie tax taxes a child's unearned income above a set threshold at the parents' marginal rate, preventing families from shifting investment income to a child's lower bracket. It commonly affects UGMA/UTMA custodial accounts.

When an investor converts a traditional IRA to a Roth IRA, the amount converted is generally:

• a.Not taxed at conversion, but taxed as ordinary income when withdrawn in retirement
• b.Subject to a 10% early-withdrawal penalty if the owner is under 59½, plus ordinary income tax
• c.Taxable as ordinary income in the year of conversion, after which qualified future growth is tax-free✓
• d.Taxed at long-term capital gain rates if the traditional IRA was held more than one year

A Roth conversion is taxed as ordinary income, on the pre-tax amount converted, in the year of the conversion; afterward qualified withdrawals, including earnings, are tax-free. The conversion is not tax-free, and the tax is not deferred until retirement (that describes a traditional IRA). It is not taxed at capital gain rates however long the IRA was held, and the 10% early-withdrawal penalty does not apply to the conversion itself if the funds stay in the Roth.IRS Publication 590-A, Rollovers and conversions to Roth IRAs

A Section 457 deferred compensation plan is most commonly available to employees of:

• a.Employees of publicly traded corporations, as the usual alternative to a 401(k) plan
• b.Self-employed individuals with no employees
• c.Small-business owners and their employees, as an IRA-based plan funded by the employer
• d.State and local governments and certain tax-exempt organizations✓

A Section 457 plan is offered by eligible employers, which the Internal Revenue Code defines as states, their political subdivisions and agencies, and other tax-exempt organizations (IRC 457(e)(1)). Employees of publicly traded corporations typically have 401(k) plans, while self-employed individuals and small businesses typically use SEP, SIMPLE or solo plans. 403(b) plans serve public schools and nonprofits.26 U.S.C. 457(e)(1) (eligible employer)

A SEP IRA is a retirement plan primarily designed for:

• a.Employees of large corporations who defer part of their pay through payroll deductions
• b.Investors seeking tax-free qualified withdrawals, because contributions are made with after-tax dollars
• c.Small employers, funded mainly by the employees' own salary deferrals with an employer match
• d.Self-employed individuals and small-business owners, funded by employer contributions✓

A Simplified Employee Pension (SEP) lets an employer of any size, including a self-employed individual, make tax-deductible contributions to traditional IRAs set up for the owner and each eligible employee, with minimal administration. Only the employer contributes, so employee salary deferrals describe a 401(k) or SIMPLE IRA; after-tax contributions with tax-free qualified withdrawals describe a Roth. SEP withdrawals in retirement are taxed as ordinary income.IRS, Simplified Employee Pension plan (SEP)

Compared with a 529 plan, a Coverdell Education Savings Account (ESA):

• a.Allows contributions up to the gift-tax annual exclusion with no income phase-out, as a 529 plan does
• b.Allows tax-free withdrawals for college costs only and never for elementary or secondary school expenses
• c.Has no age limit, so the balance can remain in the account tax-free for the beneficiary's entire life
• d.Has a relatively low annual contribution limit and phases out for higher-income contributors✓

A Coverdell ESA caps total annual contributions at $2,000 per beneficiary and phases out for higher-income contributors, whereas 529 plans allow far larger contributions with no federal income phase-out. A Coverdell can pay qualified elementary and secondary expenses as well as college costs, and any balance must generally be distributed within 30 days after the beneficiary reaches age 30 unless the beneficiary has special needs.IRS Topic No. 310, Coverdell education savings accounts

A key feature of an UGMA or UTMA custodial account is that:

• a.The donor can reclaim the assets at any time if the child's circumstances change
• b.Assets are an irrevocable gift to the minor and pass to the child's control at the age of majority✓
• c.Assets must be turned over to the child at age 18 in every state
• d.Contributions are deductible to the donor up to the annual gift-tax exclusion

Gifts to an UGMA/UTMA account are irrevocable and belong to the one named minor, with the custodian managing them until the child reaches the age of majority set by state law, when control passes to the child. The donor cannot take the assets back, the age at which control transfers is not 18 everywhere, and contributions are gifts, not tax deductions.

A financial planner who runs a Monte Carlo simulation for a retirement plan is primarily trying to:

• a.Guarantee a specific retirement balance by projecting one fixed rate of return for every year
• b.Estimate the probability that a plan will succeed across many randomized market scenarios✓
• c.Predict the exact return the market will earn in each future year so contributions can be timed
• d.Determine the most tax-efficient order in which to withdraw from taxable and retirement accounts

Monte Carlo simulation runs many randomized return scenarios to estimate the probability that a plan meets its goals, such as not running out of money. It expresses outcomes as probabilities, not guarantees: a single fixed-rate projection is what falsely suggests a guaranteed balance, no model predicts the exact return of any year, and choosing a tax-efficient withdrawal order is a separate planning question.

After a strong stock rally pushes a 60/40 portfolio to 70/30, rebalancing to target would involve:

• a.Leaving the portfolio unchanged so the winning asset class can keep compounding
• b.Buying more stocks to ride the upward trend
• c.Selling bonds and using the proceeds to buy more stocks, moving the mix to 80/20
• d.Selling some appreciated stocks and buying bonds to restore the 60/40 mix✓

Rebalancing trims the asset class that has grown beyond its target and adds to the underweight class, restoring the 60/40 mix and enforcing a disciplined sell-high, buy-low approach that controls risk. Doing nothing, buying more stocks or shifting further into stocks lets the drift continue and concentrates risk in the asset class that has already risen.

A systematic withdrawal plan from a mutual fund allows a retiree to:

• a.Guarantee the account will last for life, provided the withdrawal rate stays under 4% a year
• b.Withdraw funds free of tax, because each payment is treated as a return of principal
• c.Receive regular payments, with the risk the account may be exhausted if withdrawals outpace returns✓
• d.Lock in a guaranteed lifetime income stream backed by an insurance company's claims-paying ability

A systematic withdrawal plan pays out regular amounts, whether a fixed dollar amount, fixed percentage or fixed period, but if withdrawals exceed investment returns the principal can be depleted. It provides income, not a guarantee of permanence: no withdrawal rate guarantees the account will last for life, the payments can include taxable gains, and a guaranteed lifetime income backed by an insurer is what an annuity offers, not a mutual fund withdrawal plan.

An investor seeking a rising stream of income over time would be most attracted to:

• a.Stocks of financially strong companies with a history of consistently increasing their dividends✓
• b.Preferred stock paying a fixed dividend that does not change over the life of the issue
• c.Zero-coupon bonds held to maturity
• d.Growth stocks that reinvest all earnings and pay no dividends, so returns come only from price gains

Dividend-growth investing targets quality companies that steadily raise their payouts, giving a growing income stream and some inflation protection. Preferred stock pays a fixed dividend that does not rise, and zero-coupon bonds and non-dividend growth stocks produce no current income at all.

Before recommending long-term investments, an adviser should generally first ensure the client has:

• a.A fully funded variable annuity, so that guaranteed lifetime income is in place before any other investing is considered
• b.A concentrated position in a single growth stock, to build wealth as quickly as possible
• c.An adequate emergency cash reserve, commonly several months of expenses, in liquid low-risk holdings✓
• d.A margin account approved, so that borrowed funds can cover any shortfall in liquidity

Sound planning starts with a liquid emergency reserve, often three to six months of expenses, so the client is not forced to liquidate long-term investments at a bad time. Buying an annuity, concentrating in one growth stock or relying on margin borrowing all add commitment, risk or leverage before basic liquidity and safety are in place.

Dollar-cost averaging tends to lower an investor's average cost per share over time because a fixed dollar investment:

• a.Buys the same number of shares each period, so the average cost equals the average price
• b.Waits for market declines and then invests the full amount at the lowest price
• c.Protects against loss because the average cost can never end up above the final market price
• d.Buys more shares when prices are low and fewer when prices are high✓

Investing a set dollar amount on a regular schedule automatically buys more shares when prices are low and fewer when prices are high, which lowers the average cost per share below the average price. It imposes discipline, but it does not time the market, does not buy a constant number of shares, and cannot guarantee a profit or protect against loss.

According to Modern Portfolio Theory, a rational, risk-averse investor should choose a portfolio that lies:

• a.Entirely in the single asset with the highest expected return, ignoring its correlation with other holdings
• b.At the minimum-variance point, regardless of the investor's required return
• c.Below the efficient frontier, where lower correlation produces the greatest diversification
• d.On the efficient frontier, offering the highest expected return for the investor's chosen level of risk✓

Efficient portfolios sit on the efficient frontier, providing the highest expected return for a given level of risk or the least risk for a target return, and a risk-averse investor picks the point that matches the chosen risk level. Concentrating in one asset ignores diversification, a fixed minimum-variance point ignores the required return, and points below the frontier are inefficient because a better risk-return trade-off is available.

As a client moves closer to needing the invested funds, a suitable adjustment is generally to:

• a.Hold the allocation steady, because market timing near the goal date adds risk
• b.Increase equity exposure to make up for any shortfall in savings before the funds are needed
• c.Shift gradually toward more conservative, less volatile holdings to protect accumulated capital✓
• d.Move the entire portfolio into a single high-yield bond fund to maximize current income and offset the shortfall

A shorter time horizon reduces the ability to recover from a downturn, so allocations should become more conservative as the goal nears, the logic behind target-date glide paths. Holding steady, adding equity risk or concentrating in one high-yield fund leaves or increases exposure to losses just when there is less time to recover.

To compare the skill of a portfolio manager independent of client deposits and withdrawals, the most appropriate performance measure is:

• a.The nominal coupon rate
• b.Time-weighted return✓
• c.Current yield
• d.Dollar-weighted return (internal rate of return)

Time-weighted return removes the distorting effect of the timing and size of client cash flows, isolating the manager's investment decisions. Dollar-weighted return, the internal rate of return, instead reflects the investor's actual experience including cash-flow timing.

The total return on an investment over a period includes:

• a.Only the change in price, because income is reported separately as yield
• b.Both income received (dividends or interest) and any change in the investment's price✓
• c.Only the income received during the period, expressed as a percentage of the amount originally invested
• d.Only realized gains and income, with unrealized appreciation excluded until the position is sold

Total return combines income, whether dividends or interest, with price appreciation or depreciation, realized or not, giving the most complete measure of performance. Price change alone ignores income, income alone ignores price movement (that is yield), and excluding unrealized appreciation understates the result for a position still held.

A client in the 35% federal tax bracket is comparing a 4% tax-free municipal bond with a taxable corporate bond. The taxable yield needed to match the muni on an after-tax basis is:

• a.About 6.15%✓
• b.5.40%
• c.2.60%
• d.4.00%

Taxable-equivalent yield equals the tax-free yield divided by (1 minus the tax rate): 4% divided by 0.65 equals about 6.15%. A taxable bond must yield roughly 6.15% to beat the muni after tax for this investor.

In a defined contribution plan such as a 401(k), the ultimate retirement benefit depends on:

• a.The employee's final salary and years of service under a formula the employer guarantees
• b.A pension benefit that the Pension Benefit Guaranty Corporation sets at retirement
• c.The amount contributed and the investment performance of the account, with the employee bearing the investment risk✓
• d.The employer's matching percentage alone, since employee contributions are not counted

A defined contribution plan ties the final benefit to the contributions made and the investment performance of the account, placing investment risk on the employee. A defined benefit plan instead promises a benefit based on salary and service and puts the funding and investment risk on the employer; the PBGC only insures such plans, and an employer match is just one source of contributions.