AAFM AAFM Financial Planning Principles

Question 1

What is the time value of money (TVM) concept?

Accepted Answer

A dollar today is worth more than a dollar in the future due to its earning potential

Answer

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)?

Accepted Answer

A framework for constructing diversified portfolios that maximize expected return for a given level of risk

Answer

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)?

Accepted Answer

A model relating expected return to systematic risk (beta), expressed as E(R) = Rf + β(Rm - Rf)

Answer

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?

Accepted Answer

Dividing investments among asset classes (stocks, bonds, cash, alternatives) — research shows it determines about 90% of return variability

Answer

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)?

Accepted Answer

A theory stating that asset prices fully reflect all available information, making it impossible to consistently beat the market

Answer

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.

American Academy of Financial Management (AAFM) Practice Test

American Academy of Financial Management (AAFM) Practice Test

AAFM AAFM Financial Planning Principles