AAFM AAFM Financial Planning Principles 1 — Questions and Answers
Question 1: What is the time value of money (TVM) concept?
- A dollar today is worth more than a dollar in the future due to its earning potential (Correct answer)
- Money increases in value automatically over time
- Future money is always worth more than present money
- Time has no effect on money's value
Correct answer: A dollar today is worth more than a dollar in the future due to its earning potential
TVM recognizes that money available now can earn returns through investment, making it worth more than the same amount received in the future. This is foundational to present/future value calculations.
Question 2: What is Modern Portfolio Theory (MPT)?
- A framework for constructing diversified portfolios that maximize expected return for a given level of risk (Correct answer)
- Only investing in modern companies
- A theory about digital currencies
- A method for timing the stock market
Correct answer: A framework for constructing diversified portfolios that maximize expected return for a given level of risk
MPT, developed by Harry Markowitz, demonstrates that diversification can reduce portfolio risk without sacrificing returns by combining assets with different correlations, creating an 'efficient frontier' of optimal portfolios.
Question 3: What is the Capital Asset Pricing Model (CAPM)?
- A model relating expected return to systematic risk (beta), expressed as E(R) = Rf + β(Rm - Rf) (Correct answer)
- A model for pricing commercial real estate
- A system for calculating insurance premiums
- A method for valuing antique assets
Correct answer: A model relating expected return to systematic risk (beta), expressed as E(R) = Rf + β(Rm - Rf)
CAPM calculates expected return based on the risk-free rate plus a risk premium determined by the asset's beta (sensitivity to market movements) multiplied by the market risk premium.
Question 4: What is asset allocation and why is it considered the most important investment decision?
- Dividing investments among asset classes (stocks, bonds, cash, alternatives) — research shows it determines about 90% of return variability (Correct answer)
- Buying only one type of investment
- Allocating assets equally regardless of goals
- Only investing in the best-performing asset class
Correct answer: Dividing investments among asset classes (stocks, bonds, cash, alternatives) — research shows it determines about 90% of return variability
Asset allocation strategically distributes investments across asset classes based on goals, time horizon, and risk tolerance. Studies show asset allocation explains approximately 90% of portfolio return variability over time.
Question 5: What is the efficient market hypothesis (EMH)?
- A theory stating that asset prices fully reflect all available information, making it impossible to consistently beat the market (Correct answer)
- Markets are always inefficient
- Only insiders can profit from markets
- All stocks are equally good investments
Correct answer: A theory stating that asset prices fully reflect all available information, making it impossible to consistently beat the market
EMH (Eugene Fama) proposes three forms: weak (past prices reflected), semi-strong (all public information reflected), and strong (all information including insider knowledge reflected), each with different implications for investment strategy.
Question 6: What is the Sharpe Ratio and how is it used?
- A measure of risk-adjusted return calculated as (portfolio return - risk-free rate) / portfolio standard deviation (Correct answer)
- The ratio of shares to bonds in a portfolio
- A tax calculation method
- A measure of market volatility only
Correct answer: A measure of risk-adjusted return calculated as (portfolio return - risk-free rate) / portfolio standard deviation
The Sharpe Ratio measures excess return per unit of risk, allowing comparison of investments or portfolios on a risk-adjusted basis. Higher ratios indicate better risk-adjusted performance.
AAFM AAFM Financial Planning Principles 1
What is the time value of money (TVM) concept?