CFP Risk Assessment & Management 2 — Questions and Answers
Question 1: A client has a 10-year investment horizon and moderate risk tolerance. Which of the following best describes the role of time horizon in risk capacity?
- Longer horizons reduce risk capacity because more time means more exposure
- Longer horizons increase risk capacity because there is more time to recover from losses (Correct answer)
- Time horizon has no effect on risk capacity, only risk tolerance matters
- A 10-year horizon is too short to hold any equity exposure
Correct answer: Longer horizons increase risk capacity because there is more time to recover from losses
A longer time horizon increases risk capacity because the investor has more time to recover from market downturns before needing the funds.
Question 2: Which type of risk refers to the possibility that inflation will erode the purchasing power of an investment's returns?
- Credit risk
- Liquidity risk
- Purchasing power risk (Correct answer)
- Reinvestment risk
Correct answer: Purchasing power risk
Purchasing power risk (inflation risk) is the danger that rising prices will reduce the real value of investment returns over time.
Question 3: A client asks about diversification. Which statement about diversification is MOST accurate?
- Diversification eliminates all investment risk
- Diversification reduces systematic risk but not unsystematic risk
- Diversification reduces unsystematic risk but not systematic risk (Correct answer)
- Diversification is only effective for bond portfolios
Correct answer: Diversification reduces unsystematic risk but not systematic risk
Diversification reduces unsystematic (company-specific) risk, but systematic (market-wide) risk cannot be diversified away.
Question 4: What does a beta of 1.5 indicate about a stock relative to the overall market?
- The stock is 50% less volatile than the market
- The stock is expected to move 1.5% for every 1% move in the market (Correct answer)
- The stock has a 1.5% annual return above the market
- The stock has a correlation of 1.5 with the market
Correct answer: The stock is expected to move 1.5% for every 1% move in the market
A beta of 1.5 means the stock is expected to move 1.5% for every 1% move in the benchmark market index, indicating higher volatility.
Question 5: When assessing a client's risk tolerance using a questionnaire, a CFP professional should be aware that:
- Questionnaire results are legally binding and cannot be overridden
- Stated risk tolerance often overstates actual tolerance during bull markets (Correct answer)
- Risk tolerance questionnaires eliminate the need for ongoing monitoring
- Clients always accurately report their true emotional reaction to losses
Correct answer: Stated risk tolerance often overstates actual tolerance during bull markets
During bull markets, clients often overstate their risk tolerance because they haven't experienced significant losses; actual behavior under stress may differ from stated preferences.
Question 6: A client's portfolio lost 25% last year, and they are now requesting a much more conservative allocation. This behavioral response is BEST described as:
- Loss aversion leading to recency bias (Correct answer)
- Overconfidence bias
- Mental accounting
- Anchoring bias
Correct answer: Loss aversion leading to recency bias
Loss aversion combined with recency bias causes investors to overweight recent painful experiences and shift to overly conservative allocations after market declines.
Question 7: Which of the following is an example of unsystematic risk?
- A global recession causing all equity markets to decline
- A central bank raising interest rates affecting bond prices
- A pharmaceutical company losing a major patent lawsuit (Correct answer)
- Inflation reducing the real return of all fixed-income investments
Correct answer: A pharmaceutical company losing a major patent lawsuit
Unsystematic risk is company-specific or industry-specific risk, such as a single company losing a patent lawsuit, which can be reduced through diversification.
CFP Risk Assessment & Management 2
A client has a 10-year investment horizon and moderate risk tolerance.
Which of the following best describes the role of time horizon in risk capacity?