CFP Investment Planning & Portfolio Management 2 — Questions and Answers
Question 1: What is asset allocation, and why is it considered the most important decision in portfolio construction?
- Selecting individual securities; it determines specific return outcomes
- Dividing investments among asset classes such as stocks, bonds, and cash; research shows it explains the majority of long-term portfolio return variability (Correct answer)
- Timing when to enter and exit markets; market timing drives most returns
- Choosing between active and passive management; management style determines fees
Correct answer: Dividing investments among asset classes such as stocks, bonds, and cash; research shows it explains the majority of long-term portfolio return variability
Asset allocation is the strategic division of investments among broad asset classes, and studies (Brinson et al.) show it explains over 90% of the variability in long-term portfolio returns.
Question 2: What is rebalancing a portfolio and what is its primary purpose?
- Replacing underperforming funds with better-performing ones
- Restoring a portfolio to its target asset allocation after market movements have caused drift (Correct answer)
- Reducing portfolio fees by switching to lower-cost index funds
- Maximizing returns by overweighting the best-performing asset class
Correct answer: Restoring a portfolio to its target asset allocation after market movements have caused drift
Rebalancing involves selling assets that have grown above target weights and buying assets that have fallen below target weights to restore the intended risk profile.
Question 3: Which bond characteristic measures the price sensitivity of a bond to changes in interest rates?
- Yield to Maturity
- Coupon Rate
- Duration (Correct answer)
- Credit Rating
Correct answer: Duration
Duration measures the sensitivity of a bond's price to changes in interest rates; a higher duration means greater price volatility for a given interest rate change.
Question 4: What is the difference between systematic risk and unsystematic risk?
- Systematic risk can be eliminated through diversification; unsystematic risk cannot
- Systematic risk is market-wide risk that cannot be diversified away; unsystematic risk is company or industry-specific risk that can be reduced through diversification (Correct answer)
- Systematic risk applies only to bonds; unsystematic risk applies only to stocks
- Both types of risk can be completely eliminated with a sufficiently large portfolio
Correct answer: Systematic risk is market-wide risk that cannot be diversified away; unsystematic risk is company or industry-specific risk that can be reduced through diversification
Systematic (market) risk affects the entire market and cannot be diversified away, while unsystematic (specific) risk relates to individual securities and can be reduced through diversification.
Question 5: Which investment vehicle offers built-in diversification and allows investors to buy or sell shares throughout the trading day at market prices?
- Open-end mutual fund
- Closed-end fund
- Exchange-Traded Fund (ETF) (Correct answer)
- Unit Investment Trust (UIT)
Correct answer: Exchange-Traded Fund (ETF)
ETFs trade on exchanges throughout the day at market prices (like stocks) while providing exposure to a diversified basket of securities, combining features of mutual funds and individual stocks.
Question 6: According to the Capital Asset Pricing Model (CAPM), what is the expected return of an investment?
- Risk-free rate plus the product of beta and the equity risk premium (Correct answer)
- Standard deviation multiplied by the market return
- Dividend yield plus earnings growth rate
- The geometric mean of all historical annual returns
Correct answer: Risk-free rate plus the product of beta and the equity risk premium
CAPM: Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate), where the second term represents compensation for systematic risk.
CFP Investment Planning & Portfolio Management 2
What is asset allocation, and why is it considered the most important decision in portfolio construction?