CHAPTER 1: Quantitative Methods - Introduction

The Series 66 is a combination of the Series 65 (Investment Advisor Exam) and the Series 63 (Uniform State Law Agent Exam) This section foc!ses on the s"i##s and "now#edge needed b$ an Investment Advisor (IA) to %rovide investment advice to c#ients Series 66& Textboo"s'Software ( )ideos The Series 66 tests $o!r abi#it$ to !nderstand the conce%t of the time va#!e of mone$' as we## as the different meas!res of %otentia# rates of ret!rn

Quantitative Methods - Time Value of Mone

The conce%t of the time va#!e of mone$ ta"es into acco!nt that a do##ar received toda$ is worth more than a do##ar received in the f!t!re *inancia# %#anners m!st ro!tine#$ ca#c!#ate the f!t!re va#!e of investments in order to he#% c#ients %#an for goa#s s!ch as retirement

Future Value +hen %#anning an investment strateg$' it is !sef!# to be ab#e to %redict what an investment is #i"e#$ to be worth in the f!t!re' ta"ing the im%act of com%o!nd interest into acco!nt This form!#a a##ows $o! (or $o!r ca#c!#ator) to do ,!st that&

Pn = P0(1+r)n P0 is the original amount invested Pnis the future value of P0 nis the number of compounding periods (years, months, etc ) r is the rate of interest

As the fo##owing exam%#es i##!strate' when $o! increase the fre-!enc$ of com%o!nding' $o! a#so increase the f!t!re va#!e of $o!r investment .ow m!ch wi## an investment' (worth /01'111 toda$)' be worth 01 $ears from now at a rate of 234

51 6 /01'111 5n is the f!t!re va#!e of 51 n 6 01 $ears r 6 23 Exam%#e 0& If interest is com%o!nded ann!a##$' the f!t!re va#!e (5 n) is /73'689 01'111:(0 12)01:0 6 /73'689 Exam%#e 7& If interest is com%o!nded month#$' the f!t!re va#!e (5 n) is /79'509 01'111:(0;(1 12<07)01:07 6 /79'509 The same conce%ts can he#% $o! to ca#c!#ate the amo!nt needed toda$ to reach the f!t!re va#!e of a desired investment *or exam%#e' if a c#ient wishes to retire with /0 mi##ion' it wo!#d be !sef!# to "now how m!ch she needs to save each $ear to reach that goa# =o! can sim%#$ reverse the f!t!re va#!e form!#a to ca#c!#ate the %resent va#!e re-!ired&

P0 = Pn ! (1+ r) n

Quantitative Methods - !et Present Value "!PV#

The time va#!e of mone$ ca#c!#ations can a#so be !sed to ca#c!#ate the net %resent va#!eof a series of cash f#ows' or of an investment %#!s a series of cash f#ows >asica##$' the net %resent va#!e ca#c!#ation com%ares the va#!e of a do##ar toda$ with the va#!e of that do##ar in the f!t!re' after ta"ing rate of ret!rn and<or inf#ation into acco!nt. +hen eva#!ating an investment' it is desirab#e for the net %resent va#!e to be greater than the amo!nt invested? otherwise' there is no incentive to ma"e that

investment

Exam Tips and Tricks A typical time value of money question will look something like this: 1. "f #10,000 is invested at $%, compounded monthly, it &ould be &orth #1',1() in 10 years #1',1() &ould be the investment*s +++++++++++++ a Interna# rate of ret!rn b 5resent va#!e c Ex%ected ret!rn d *!t!re va#!e
The correct answer is "d" - the ending value is known as the future value.

Quantitative Methods - Rates of Return

@ifferent meas!res can be !sed when disc!ssing %otentia# rates of ret!rn The interna# rate of ret!rn !sed in time va#!e of mone$ ca#c!#ations cannot be direct#$ fo!nd b$ form!#a It can be a%%roximated b$ tria# and error' b!t in the rea# wor#d' it is sim%#$ fo!nd b$ in%!tting %resent va#!e' f!t!re va#!e' and the n!mber of com%o!nding %eriods into a financia# ca#c!#ator Severa# meas!res of ret!rn can be se#ected for s!ch a ca#c!#ation&

Interna# rate of ret!rn (IAA) B This interest rate ma"es the net %resent va#!e of a series of cash f#ows e-!a# to Cero The IAA can on#$ be ca#c!#ated b$ tria# and error (or with a financia# ca#c!#ator) !n#ess the investment has on#$ a sing#e cash f#ow' in which case the ca#c!#ation is as fo##ows&

"nternal rate of return = Payoff ! "nvestment , 1

An exam%#e of this wo!#d be an investment of /0'111 that wo!#d ret!rn /0'011 in one $ear The form!#a wo!#d %rod!ce 0011<0111 B 0 which e-!a#s 0 01 B 0 which e-!a#s 01 (013)

Look Out! -he fact that internal rate of return presumes that the net present value of the inflo&s and outflo&s e.uals /ero seems counterintuitive "t may be helpful to thin0 of the internal rate of return as the discount rate at &hich the e1pected returns e.ual the initial investment 2o&ever, on the e1am, 3net present value e.uals /ero3 &ill be the correct ans&er

Aea# ret!rn B This is a#so "nown as inf#ationBad,!sted ret!rn >$ ad,!sting the stated (nomina#) ret!rn of an investment to consider inf#ation' the investor has a more rea#istic assessment of ret!rn Learn more abo!t this in the Deas!ring 5ortfo#io Aet!rns section on >ond =ie#ds

Ex%ected ret!rnB This is the average of the %robabi#it$ distrib!tion of %ossib#e ret!rns' ca#c!#ated b$ ta"ing the %robabi#it$ of each %ossib#e ret!rn o!tcome and m!#ti%#$ing it b$ the ret!rn o!tcome' then adding each of these together to get the ex%ected ret!rn .

Ais"Bad,!sted ret!rn B This ca#c!#ation a##ows an investor to determine if the amo!nt of ret!rn received is commens!rate with the ris" ta"en It incor%orates both beta and the ris"Bfree rate of ret!rn (t$%ica##$ the c!rrent rate of shortBterm Treas!r$ bi##s)

Look Out! 4oo0 for .uestions on both the definition of total return and the inflation component of real return 5ny ans&ers that involve ris0 are incorrect

Look Out! 6onsider this sample .uestion7 5 client buys a 89F 10% bond at 10: -he bond matures in 10 years ;hat is the current yield< a b c d 01 083 2 573 2 623 2 033

The correct answer is "b", since current yield is found by dividing the annual interest payment (in this case $1 ! by the current market price (in this case $1. " !.

CHAPTER $: Measurin% Portfolio Returns - Introduction

=easuring Portfolio >eturns There are a n!mber of wa$s to ca#c!#ate the investment ret!rn of an acco!nt Some of these (rea# ret!rn and ris"Bad,!sted ret!rn) were disc!ssed in the E!antitative Dethods section =o! wi## not be tested on the act!a# form!#as' so the$ are not inc#!ded here (other than those %rovided for c#arit$) In this section weF## foc!s on ret!rn meas!res s!ch as the fo##owing&

Aet!rn on investment B This is the c#assic meas!re of %erformance' ta"ing into acco!nt a## cash f#ows (inc#!ding dividends' interest' ret!rn of %rinci%a#' and ca%ita# gains) To ca#c!#ate' sim%#$ divide the s!m of a## cash f#ows b$ the n!mber of $ears the investment is he#d' and then divide that amo!nt b$ the origina# amo!nt invested

.o#ding %eriod ret!rn , Aefers to the ret!rn for the %eriod of time the investment was act!a##$ he#d This can be more meaningf!# than an ann!a#iCed rate of ret!rn' %artic!#ar#$ for investments he#d short term The standard deviation of ret!rns de%ends on the ho#ding %eriod'

since stoc" ret!rns are more vo#ati#e over shorter %eriods As a res!#t& o the shorter the ho#ding %eriod' the greater the variabi#it$ of the ret!rn?
o

the #onger the ho#ding %eriod' the sma##er the variabi#it$ of the ret!rn

Ann!a#iCed ret!rnB A#so referred to as average ret!rn' this ex%resses the geometric rate of ret!rn of a %ortfo#io over an$ given %eriod into an ann!a# basis B in other words' it %rovides the average ann!a# ret!rn %er $ear over that %eriod

Ais"Bfree rate of ret!rn B The c!rrent rate for 21 da$ Treas!r$ bi##s is t$%ica##$ !sed in ca#c!#ations s!ch as ris"Bad,!sted ret!rn and the Shar%e ratio

Tota# ret!rn B This incor%orates the rate of ret!rn from a## so!rces' inc#!ding a%%reciation (or de%reciation)' dividends and interest

Measurin% Portfolio Returns - &ther Terms

The fo##owing terms are a#so !sef!# in !nderstanding the meas!res of %ortfo#io ret!rns and ris"s&

Ais" %remi!mB The ris" %remi!m is the higher ret!rn that is ex%ected for ta"ing on the greater ris" associated with investing in a growth stoc" vers!s a stoc" from a more estab#ished com%an$

Ex%ected ret!rn B Since the ex%ected ret!rn is the average of the %robabi#it$ of %ossib#e rates of ret!rn' it is b$ no means a g!aranteed rate of ret!rn .owever' it can be !sed to forecast the f!t!re va#!e of a %ortfo#io and %rovides a g!ide from which to meas!re act!a# ret!rns It is an integra# com%onent of the ca%ita# asset %ricing mode#' which ca#c!#ates the ex%ected ret!rn based on the %remi!m of the mar"et rate over the ris"Bfree ret!rn as we## as the ris" of the investment re#ative to the mar"et as a who#e (beta)

>enchmar" %ortfo#ios , A common wa$ to eva#!ate %ortfo#io ret!rns is to com%are them to a benchmar" s!ch as an index These are the most common benchmar"s& o Standard ( 5oorFs 511 B for #argeBca% stoc"s o A!sse## 7111 , for sma##Bca% stoc"s o E!ro%e' A!stra#ia and *ar East Index (EA*E) , for internationa# stoc"s

Measurin% Portfolio Returns - 'ond (ields

An$ disc!ssion of %ortfo#io ret!rns m!st a#so inc#!de the variet$ of wa$s that bond income ma$ inf#!ence a %ortfo#ioFs rate of ret!rn +hi#e the stated (nomina#) interest rate on a bond might a%%ear to be the on#$ meas!re of a bond $ie#d' it is on#$ acc!rate if $o! b!$ a bond at %ar and ho#d it !nti# the bond mat!res .owever' man$ investors b!$ a bond at a %rice above or be#ow %ar' and man$ se## %rior to mat!rit$ The fo##owing meas!res are !sed to ref#ect these circ!mstances&

=ie#d to mat!rit$ B This is the ret!rn based on the act!a# %!rchase %rice of the bond It ta"es an$ %remi!m or disco!nt over %ar into acco!nt and !ses the act!a# time to mat!rit$ for the n!mber of com%o!nding %eriods If the bond was %!rchased at %ar' the $ie#d to mat!rit$ wi## e-!a# the stated co!%on rate

=ie#d to ca## B This is a simi#ar ca#c!#ation' b!t it !ses the ca## date for the n!mber of com%o!nding %eriods and incor%orates an$ ca## %remi!m into the f!t!re va#!e

G!rrent $ie#d B This is sim%#$ the ann!a# income divided b$ the mar"et va#!e of the bond If the bond is trading at a %remi!m' the c!rrent $ie#d wi## be #ess than the nomina# $ie#d If the bond is trading at a disco!nt' the c!rrent $ie#d wi## be greater than the nomina# $ie#d

Aea# interest rate , The investor receives this rate after inf#ation is ta"en into acco!nt In essence' the nomina# interest rate 6 the rea# interest rate %#!s an inf#ation %remi!m The inf#ation %remi!m is

t$%ica##$ higher for bonds with #onger mat!rities

Exam Tips and Tricks 6onsider this sample .uestion7 -he method of evaluating investment returns that calculates the interest rate &hich discounts cash inflo&s and outflo&s to a present value of /ero is called7 a b c d inf#ationBad,!sted ret!rn interna# rate of ret!rn tota# ret!rn net %resent va#!e

The correct answer is "b"# "d" is incorrect because the method referred to incorporates the concept of net present value, but it is not a definition of that term.

CHAPTER ): Anal *in% (our Client+s ,inancial Profile Introduction

Hne of the %rimar$ res%onsibi#ities of an IA is to ma"e s!re that investment advice given is s!itab#e for the %artic!#ar c#ient The best wa$ to ens!re that $o!r investment advice or financia# %#anning recommendations are s!itab#e is to deve#o% a c#ient %rofi#e >e s!re to co##ect the fo##owing information at the beginning of $o!r advisor$ re#ationshi% and to !%date the %rofi#e as $o!r c#ientFs sit!ation changes over time& T$%e of c#ient G!rrent stat!s *inancia# goa#s Ga%ita# and other needs G!rrent investments Ais" to#erance Tax iss!es IonBfinancia# considerations

Anal *in% (our Client+s ,inancial Profile - Client T -e

In addition to individ!a#s and married co!%#es' there are man$ other %otentia# c#ient t$%es >eca!se the goa#s of an organiCation are #i"e#$ to be ver$ different from those of an individ!a#' $o! sho!#d be fami#iar with these other c#ient t$%es& Partnerships

>!siness %artnershi%B In this %artnershi%' a## %artners are e-!a##$ res%onsib#e for b!siness debts and share e-!a##$ in b!siness %rofits (which %ass thro!gh to be re%orted on each %artnerFs %ersona# income tax ret!rn)

Limited %artnershi% , .ere the genera# %artner is res%onsib#e for managing the b!siness and has !n#imited #iabi#it$ for its debts' whi#e the #imited %artners are not res%onsib#e for an$ of the debts *ami#$ #imited %artnershi% , This arrangement is !sed %rimari#$ as a means of minimiCing estate and gift taxes' b!t m!st have a #egitimate b!siness %!r%ose (s!ch as managing investment rea# estate' fami#$ b!siness' etc )

6orporations The main advantage of a## t$%es of cor%orations is that the owners are not %ersona##$ #iab#e for the cor%orationFs debts There are three t$%es&

6 6orporation , Thesecor%orations m!st %a$ cor%orate income tax on their income' and the owners %a$ %ersona# income taxes on %rofits received as dividends ("nown as do!b#e taxation)

S Gor%oration , This arrangement is s!itab#e for sma## com%anies (#ess than 85 shareho#ders) that want the #ega# %rotection of a cor%oration b!t the f#owBthro!gh taxation of %artnershi%s (cor%orate #osses are a%%#ied to %ersona# income tax ret!rn) Limited Liabi#it$ Gor%oration , This t$%e of str!ct!re %rovides a com%an$Fs owners with %rotection from debts' b!t is taxed as if it is a so#e %ro%rietorshi%

Look Out! On the exam, you are likely to be given a description of a new business and be asked which type of corporation it most resembles. If the question states that losses are expected in the first years, "S Corporation" is the correct answer. If it is a single owner and losses are not mentioned but protection from liabilities is noted, "LLC" is usually the correct answer. (Sole proprietorship is usually the fourth choice.)

?ther 9ntities

Estates , An estate acco!nt is t$%ica##$ o%en on#$ a short time' !nti# the estate assets are distrib!ted to beneficiaries' so #ongBterm or s%ec!#ative investments are !s!a##$ not a%%ro%riate

Tr!sts , The IA m!st recommend investments that are s!itab#e for the beneficiaries of the tr!st' not for the tr!stee
Exam Tips and Tricks Consider these sample exam questions about client types:

1 ;hich business entity &ould provide a flo&,through of business income or losses as &ell as limited liability to the o&ners< a So#e 5ro%rietorshi% b Jenera# 5artnershi% c G Gor%oration d S Gor%oration The correct answer is "d"# only the $ %orporation offers both of these advantages. @ ;hich investments &ould be considered suitable for an estate account< a Treas!r$ bonds b H%tions c Done$ mar"et f!nd d Jrowth stoc" m!t!a# f!nd The correct answer is "c", since Treasury bonds, growth stock mutual funds and options are not suitable for an account with a short time

hori&on.

Anal *in% (our Client+s ,inancial Profile - Current .tatus and ,inancial /oals
6urrent Atatus >efore $o! can he#% c#ients meet their goa#s' $o! m!st have a good gras% of their c!rrent financia# sit!ations It can be !sef!# to create wor"sheets to ca%t!re the fo##owing information& Income Ex%enses Assets Liabi#ities Tax iss!es Financial Boals K*inancia# goa#sK refers to genera# investment ob,ectives' not the c#ientFs s%ecific needs s!ch as retirement at a certain age or co##ege %#ans for his<her chi#dren (see the next section on ca%ita# needs) .owever' there is certain#$ a corre#ation between the two' and it is !sef!# to "now the characteristics of each of these investment goa#s&

5reservation of ca%ita# B The investor is more concerned with safet$ than with ret!rn Treas!r$ bi##s and mone$ mar"et f!nds ma$ be most a%%ro%riate

G!rrent income B The investor needs a %ortfo#io that %rod!ces stead$ income for c!rrent #iving ex%enses >onds' ann!ities' and stoc"s with high dividends (s!ch as !ti#it$ stoc"s) ma$ be a%%ro%riate Bro&th and income B The investor is #oo"ing for a %ortfo#io that generates some income' b!t he<she is #oo"ing for ca%ita# a%%reciation as we## (often for %rotection against inf#ation) A%%ro%riate investments co!#d inc#!de a mix of bonds and stoc"s Bro&th B The investorFs goa# is #i"e#$ retirement or another event in the f!t!re' where c!rrent income is not needed A diversified stoc" or m!t!a# f!nd %ortfo#io is a%%ro%riate S%ec!#ation B The investor is #oo"ing for highBris" investments with

a %otentia# for ver$ #arge ret!rns This is rare#$ the goa# for an entire %ortfo#io' b!t rather for a s%ecific %ortion of assets Aggressive growth f!nds and sma##Bca% iss!es ma$ be most a%%ro%riate
Exam Tips and Tricks Consider this sample exam question:

1 9ach of the mutual funds belo& might be suitable for an investor primarily see0ing income investments 9C69P-7 a government bond f!nd b ba#anced f!nd c sector f!nd d mone$ mar"et f!nd The correct answer is "c", since sector funds contain only stock investments and are primarily growth-oriented.

Anal *in% (our Client+s ,inancial Profile - Ca-ital and &ther !eeds0 Current Investments and Ris1 Tolerance
6apital and ?ther Deeds The c#ientFs s%ecific goa#s sho!#d be disc!ssed in detai# +hi#e the need for retirement and co##ege f!nding is near#$ !niversa#' be s!re to %robe for other goa#s s!ch as starting a b!siness' he#%ing other fami#$ members or b!$ing a vacation home A "e$ consideration for an$ of these goa#s is the time horiCon' which affects both the choice of investment strateg$ and the amo!nt of ann!a# savings needed to reach the goa# Hther needs m!st be disc!ssed and %#anned for as we##' inc#!ding the fo##owing&

9mergency reserves B +hi#e three to six monthsF #iving ex%enses are considered standard for emergenc$ savings' other factors co!#d dictate a #arger or sma##er need for #i-!id savings

Life ins!rance B If the c#ient has a fami#$ whose income needs cannot be met thro!gh c!rrent assets' #ife ins!rance is needed The tota# amo!nt and t$%e of ins!rance wo!#d de%end on c#ient circ!mstances

?ther insurance B The IA sho!#d review the c#ientFs disabi#it$ and hea#th ins!rance coverage' since an$ investment or estate %#ans co!#d be disr!%ted if this coverage is inade-!ate

6urrent "nvestments >efore ma"ing investment recommendations' it is im%ortant for the IA to !nderstand the c#ientFs c!rrent ho#dings and what strategies were !sed to create them The c#ient ma$ wish to #i-!idate some or a## of these ho#dings and reinvest in a new %ortfo#io' or he or she ma$ want to retain a## c!rrent ho#dings The IA m!st consider these matters before ma"ing recommendations >is0 -olerance A %rimar$ consideration in recommending s!itab#e investments is an !nderstanding of the c#ientFs ris" to#erance If a %artic!#ar c#ient is !ncomfortab#e with the inherent ris" of agrowth %ortfo#io or of a s%ecific investment o%tion' it is not s!itab#e B even if it a%%ears to match the c#ientFs time horiCon and financia# goa#s Hf co!rse' an IA ma$ tr$ to ed!cate the c#ient as to ris"<reward tradeoffs and the histor$ of simi#ar investments' b!t the c#ient is the fina# arbiter of how m!ch ris" he or she is wi##ing to ta"e Dan$ investors do not !nderstand how to determine the #eve# of ris" their individ!a# %ortfo#ios sho!#d bear' the artic#e 'etermining (isk and the (isk )yramid disc!sses how one can determine his or her ris" %reference' and how the ris" %$ramid is !sef!# in devising an a%%ro%riate asset mix

Anal *in% (our Client+s ,inancial Profile - Ta2 Issues

"ncome -a1 Income taxation can have a significant im%act on $o!r c#ientFs %ortfo#io and financia# %#ans It is cr!cia# that $o! f!##$ !nderstand the tax im%#ications of the recommendations $o! ma"e An individ!a# ma$ be s!b,ect to one of these fo!r t$%es of income tax&

Hrdinar$ incomeB This inc#!des a## income earned from sa#ar$' commission and b!siness income Some investment gains' s!ch as

bond interest and withdrawa#s from Traditiona# IAAs and com%an$ retirement %#ans' are taxed at Kordinar$ incomeK rates

Ga%ita# gains , This refers to income res!#ting from the a%%reciation of a ca%ita# asset (e g stoc"s' rea# estate' coins) Ga%ita# gains are not rea#iCed !nti# the asset is so#d Ga%ita# gains are c#assified as short term or #ong term& o Short term , Assets he#d for 07 months or #ess are considered shortBterm ca%ita# gains and are taxed at ordinar$ income rates Long term , Assets he#d for #onger than 07 months benefit

from red!ced tax rates (based on $o!r margina# tax brac"et) Those in the #owest tax brac"ets (013 or 053) %a$ on#$ 53 ca%ita# gains tax rate' whi#e those in the higher brac"ets (753 and above) %a$ on#$ 053 @ividends , 5rior to 7113' dividends were taxed at ordinar$ income rates' a#ong with bond interest @!e to a change in tax #aw' K-!a#ifiedK stoc" dividends (common and %referred) are now taxed #i"e ca%ita# gains' with a maxim!m income tax rate of 053 AEIT dividends do not -!a#if$ for this s%ecia# treatment 5assive income , Income from so!rces s!ch as rea# estate #imited %artnershi%s or direct#$ owned (b!t %rofessiona##$ managed) rea# estate is taxab#e at ordinar$ income rates and can on#$ be red!ced b$ %assive #osses' not b$ ca%ita# gain #osses

2olding Period Since the difference between shortBterm ca%ita# gains and #ongBterm ca%ita# gains taxation rates is so significant' $o! need to !nderstand exact#$ when a sec!rit$ is considered %!rchased and when it is considered so#d

The ho#ding %eriod begins the da$ after the sec!rit$ is %!rchased (not the sett#ement date)

The ho#ding %eriod ends the da$ of the sa#e It is im%ortant to "ee% detai#ed records of these dates' to ens!re that a sec!rit$ is not so#d too soon and th!s -!a#ifies for %referentia# tax treatment

6ost Easis Dere#$ "nowing the tax rates is not eno!gh for an IA A "e$ conce%t to !nderstand is cost basis' since the amo!nt of ca%ita# gains to be taxed is ca#c!#ated b$ s!btracting the investorFs cost from the sa#es %roceeds To determine the cost basis of an investment' start with the origina# %rice (%#!s an$ transaction costs) Iext' add the do##ar va#!e of dividends that were reinvested This wo!#da%%#$ to both stoc"s in a dividendB reinvestment %rogram and m!t!a# f!nds where dividends are a!tomatica##$ reinvested Aeinvested ca%ita# gains are a#so added to the cost basis for m!t!a# f!nds
Cost basis = Original Price + transaction costs + dividends

If $o! inherit an investment' $o!r cost basis is the va#!e of the asset as of the decedentFs date of death This is "nown as a ste%%edB!% cost basis A#so' the ho#ding %eriod is a#wa$s considered #ongBterm' even if the deceased hadnFt owned the investment for 07 months before death

If $o! receive an investment as a gift' there are act!a##$ two different cost bases that a%%#$& 0 The act!a# cost basis of the giver 7 The mar"et va#!e on the date of the gift

The best wa$ to ex%#ain how this wor"s is to !se an exam%#e LetFs sa$ $o! are given shares of stoc"' and the origina# ownerFs cost basis was /81 a share Hn the date of the gift' the shares are trading at /61 If $o! se## the shares in the f!t!re' the basis for a gain is /81 a share' and the basis for a #oss is /61 If $o! se## the shares for a %rice between /61 and /81' $o! have neither a taxab#e gain nor a taxab#e #oss

Anal *in% (our Client+s ,inancial Profile - !ettin% Ca-ital /ains and 3osses and 4ash .ales

Detting 6apital Bains and 4osses If an investor ma"es a n!mber of trades in a %artic!#ar $ear' the end res!#t co!#d be a mix of #ongBterm and shortBterm ca%ita# gains and ca%ita# #osses The IAS is s%ecific as to how these gains and #osses are to be netted against each other .ere are the ste%s&

Iet shortBterm gains against shortBterm #osses Iet #ongBterm gains against #ongBterm #osses If both ho#ding %eriods res!#t in gains (or both in #osses)' the$ are re%orted se%arate#$ on Sched!#e @

If one ho#ding %eriod res!#ts in a gain and the other in a #oss' the$ are then netted against each other

If ca%ita# #osses exceed ca%ita# gains' !% to /3'111 can be ded!cted against ordinar$ income in an$ one $ear

Un!sed ca%ita# #osses can be carried forward indefinite#$ to f!t!re $ears B each $ear' !n!sed ca%ita# #osses wi## first be netted against the c!rrent $earFs ca%ita# gains' fo##owed b$ the /3'111 ded!ction against ordinar$ income

;ash Aales If $o! own a stoc" that has gone down in va#!e' b!t $o! be#ieve it wi## rise significant#$ in the f!t!re' it co!#d be tem%ting to se## the stoc" and en,o$ the res!#ting ca%ita# #oss and then b!$ it bac" so $o! can en,o$ the f!t!re ca%ita# gain >!t the IAS does not %ermit $o! to ta"e the #oss if $o! b!$ the same (or simi#ar) sec!rit$ bac" within 31 da$s of the sa#e This is "nown as awash sa#e There are severa# wa$s to avoid the wash sa#e r!#e and sti## ta"e advantage of the !nder#$ing strateg$&

+ait more than 31 da$s to b!$ bac" the sec!rit$ >!$ a sec!rit$ with simi#ar characteristics (e g se## shares of A>G

growth m!t!a# f!nd and b!$ shares of L=M growth m!t!a# f!nd) The wash r!#e a%%#ies to transactions before and after the se## date *or exam%#e' $o! cannot b!$ additiona# shares of the sec!rit$ on Hctober 0' se## the origina# shares on Hctober 71 and then b!$ more shares of the same sec!rit$ on Iovember 01 In essence' the wash sa#e r!#e covers a %eriod of 60 da$s& the se## date %#!s 31 da$s before and 31 da$s after that date

Look Out! 8on*t be confused by the prohibition against buying bac0 the 3same (or similar) security3 and the strategy of 3buying a security &ith similar characteristics 3 "n the first instance, 3similar security3 refers to securities that are convertible to the sold security, (such as call options, rights, &arrants, or convertible bonds), &hich can result in o&ning the security at a later date

The artic#e Selling *osing $ecurities +or , Ta- ,dvantage contains va#!ab#e information on how to %erform taxB#oss harvesting to he#% red!ce taxes on %ortfo#io gains

Exam Tips and Tricks 6onsider these sample e1am .uestions7 1 Four client bought 100 shares of 5E6 stoc0 on Gune H0 ;hat is the first day of the follo&ing year the stoc0s could be sold for a capital gain< a N!ne 0 b N!#$ 0 c N!#$ 7 d N!ne 31 The correct answer is "c", since the holding period begins .uly 1 (the day after the purchase!. *ong-term capital gains are only permitted if the holding period is greater than one year, so the correct answer is .uly /. @ Four client has a net short,term gain of #H,000 and a net

long,term loss of #',000 ;hich of the follo&ing statements are true< " -he short,term gain is fully ta1able "" #H,000 of capital loss is deductible against earned income """ -here is a long,term loss carried for&ard of #@,000 "V -here is no loss carried for&ard a b c d I ( III I ( I) II ( III I' II' ( III

The correct answer is "c." The gain and the loss are netted and result in a $", long-term loss. $0, of that can be used in the current year as a deduction against earned income, and there will be a carry forward of $/, .

Anal *in% (our Client+s ,inancial Profile - Cor-orate and Trust Income Ta2
6orporate "ncome -a1es Gor%orations get a tax brea" for investing in common and %referred stoc"s (of com%anies other than their own)

There is a dividend exc#!sion of 813 that a%%#ies to cor%orations that own #ess than 713 of the other com%an$

If the com%an$ owns more than 713' the dividend exc#!sion is O13

Since there is no cor%orate tax brea" on bond interest (for cor%orate or government bonds)' there is no incentive for cor%orations to %!rchase these

Hf co!rse' m!nici%a# bond interest is not taxab#e to the cor%oration (!n#ess it is a %rivateB%!r%ose bond' which wo!#d be taxab#e to an

individ!a# as we##) -rust "ncome -a1es The income tax rate that a%%#ies to a tr!st de%ends on what t$%e of tr!st it is&

Aevocab#e tr!stsB these tr!sts manage assets that the owner (KgrantorK) has %#aced in the tr!st d!ring his or her own #ifetime o The grantor has the right to change or terminate the tr!st at an$ time and can serve as the tr!stee of the tr!st
o o

The tr!st becomes irrevocab#e !%on the grantorFs death Aevocab#e tr!sts are taxed at the grantorFs %ersona# income tax rate B c!rrent#$ a maxim!m of 32 63

Irrevocab#e tr!stsB these tr!sts ma$ be created d!ring the grantorFs #ifetime or ma$ be contained within a wi## and become active on#$ !%on their death o Irrevocab#e tr!sts are taxed at s%ecia# tr!st income tax rates

Anal *in% (our Client+s ,inancial Profile - Estate and /ift Ta2es
Inified 9state and Bift -a1 The tota# of a## taxab#e gifts given d!ring a %ersonFs #ifetime %#!s taxab#e amo!nts transferred !%on death are s!b,ect to a !nified estate and gift tax Estate taxes and gift taxes are interre#ated' since the federa# government a%%#ies the Unified Estate and Jift Tax Gredit (a#so "nown as the Unified Gredit) to both t$%es of transfers of %ro%ert$ >eca!se this area of tax #aw is com%#ex' c#ients with #arge estates sho!#d be advised to wor" with an estate %#anning s%ecia#ist to create an estate %#an that minimiCes %otentia# taxes +hi#e income taxes are %aid b$ the %erson who receives the income' gift

and estate taxes are %aid b$ the %erson or entit$ that transfers the mone$ Jift taxes are %aid b$ the donor' and estate taxes are %aid b$ the estate These taxes are %rogressive' meaning the tax rate increases with the siCe of the gift or estate Inified 9state and Bift -a1 6redit This amo!nt has changed significant#$ over the $ears and is sched!#ed for additiona# changes in the f!t!re

There is an !n#imited Unified Gredit for s%o!ses A s%o!se who %asses awa$ ma$ #eave an estate of an$ amo!nt to the s!rviving s%o!se witho!t s!b,ecting the estate to taxes

G!rrent#$ estates va#!ed at #ess than /5 75 mi##ion are free from taxes this amo!nt increases to /5 39 mi##ion in 7109 See the fo##owing %age for a tab#e dis%#a$ing c!rrent exc#!sion #imits

Bift ta1 e1emption According to the IAS Gode' each %erson can gift !% to /09'111 each $ear to an !n#imited n!mber of %eo%#e This is one wa$ for wea#th$ %eo%#e to red!ce their estate %rior to death A married co!%#e can gift /7O'111 %er $ear %er beneficiar$

Exam Tips and Tricks 6onsider these sample e1am .uestions7 ;hich of the follo&ing gift given in one year from an aunt to her nieces &ould D?- be subJect to gift ta1< " "" """ "V ?ne #@',000 gift to one niece -&o #1),000 gifts to t&o nieces -&o #@',000 gifts to t&o nieces ?ne #1),000 gift to one niece a I on#$ b II ( I) c II ( III

d I' II' III' ( I) The correct answer is "b" - since there is no information that the aunt is married, the transfers of $/1, would be sub2ect to gift ta-

Anal *in% (our Client+s ,inancial Profile - !on-,inancial Considerations

A n!mber of nonBob,ective iss!es can affect what investments and strategies are a%%ro%riate for a %artic!#ar investor&

Investor "now#edge and so%histication G#ient va#!es G#ient demogra%hics

Exam Tips and Tricks 6onsider this sample e1am .uestion7 1 -he ris0 tolerance of the client is D?- a factor to consider &hen ma0ing investment recommendations to &hich client type(s)7 " -rusts "" 9states """ 4imited partnerships "V 5ccredited investors a b c d I) on#$ I and II on#$ I' II' III ( I) Ione of the above

The correct answer is "d"# risk tolerance must be considered for all investors, even institutional ones.

CHAPTER 5: .-ecial Issues for Retirement Plans -

Introduction
"ntroduction There are severa# t$%es of individ!a# and em%#o$erBbased retirement %#ans that ma$ be avai#ab#e to $o!r c#ients The Series 66 exam wi## test $o! on $o!r "now#edge of the e#igibi#it$ and tax treatment of these %#ans' as we## as the s!itabi#it$ of the %#ans for different t$%es of c#ients

.-ecial Issues for Retirement Plans - Individual Retirement Accounts "IRAs#

There are two t$%es of Individ!a# Aetirement Acco!nt (IAA) B Traditiona# and Aoth Each has !ni-!e e#igibi#it$ r!#es and tax treatment' b!t the contrib!tion #imits are identica# GatchB!% #imits a#so a%%#$ to both IAA t$%es and are avai#ab#e to those aged 51 and o#der These amo!nts are sched!#ed to rise over time as shown be#ow&
YEAR 2005 2006-2007 2008 2009 Contribution $4,000 $4,000 $5,000 Indexed for inflation Catch-up $500 $1,000 $1,000 $1,000

Look Out! The limits above apply jointly to both Traditional and Roth IRAs. For example, a 40-year-old client can contribute a total maximum of $4,000 in 2005 - so he or she could contribute $1,000 to a Traditional IRA and $3,000 to a Roth IRA, but not $4,000 to each.

Iot a## t$%es of investments are %ermitted within IAAs 5ermissib#e investments inc#!de stoc"s' bonds' m!t!a# f!nds' ann!ities' government sec!rities and go#d or si#ver coins minted b$ the U S Treas!r$ Hther investments s!ch as co##ectib#es' ins!rance %o#icies' art and other t$%es of coins are not %ermitted

.-ecial Issues for Retirement Plans - Traditional IRA

An$ em%#o$ed %erson is e#igib#e to contrib!te to a Traditiona# IAA' b!t not a## s!ch contrib!tions are ded!ctib#e from income taxes @ed!ctibi#it$ is a factor of income as we## as coverage !nder an em%#o$er retirement %#an S!ch ded!ctions are s!b,ect to the fo##owing e#igibi#it$ r!#es&

If a %erson is not c!rrent#$ covered b$ a retirement %#an at wor"' IAA contrib!tions are ded!ctib#e in f!##

If a %erson is c!rrent#$ covered b$ a retirement %#an at wor"' IAA contrib!tions are ded!ctib#e on#$ if income is #ess than the #imits shown be#ow&
YEAR 2004 2005 2006 2007 Single Return $45,000-$55,000 $50,000-$60,000 $50,000-$60,000 $50,000-$60,000 Joint Return $65,000-$75,000 $70,000-$80,000 $75,000-$85,000 $80,000-$100,000

If income fa##s between the #imits shown above' the contrib!tion wi## be %artia##$ ded!ctib#e B the ded!ction is K%hased o!tK in %ro%ortion to the amo!nt b$ which the income exceeds the #ower #imit in the range *or a married co!%#e' if on#$ one s%o!se is covered b$ a %ension %#an' a different %haseBo!t r!#e a%%#ies& o If combined income is /051'111 or #ess' the contrib!tion for
o o o

the nonBcovered s%o!se is f!##$ ded!ctib#e If combined income is between /051'111 and /061'111' a %ro%ortiona# %haseBo!t a%%#ies If combined income is /061'111 or higher' no ded!ction a%%#ies These r!#es a%%#$ on#$ to the nonBcovered s%o!se? contrib!tions b$ the covered s%o!se are not ded!ctib#e
Exam Tips and Tricks On the exam, you will not be tested on the actual dollar values for the phase-out. However, you will need to know that clients with high incomes are subject to different phase-out rules.

-he follo&ing information applies to -raditional ">5s only7

Earnings are taxBdeferred !nti# withdrawn If ded!ctib#e contrib!tions are made' 0113 of withdrawa#s are s!b,ect to taxation at ordinar$ income rates If nonBded!ctib#e contrib!tions are made' a %ortion of each withdrawa# is not taxab#e +ithdrawa#s made %rior to age 52 P are s!b,ect to a 013 %ena#t$' !n#ess one of the fo##owing exce%tions a%%#ies& o @eath o @isabi#it$ o E#igib#e ed!cationa# ex%enses o *irstBtime homeBb!$ing ex%enses (!% to /01'111) o @istrib!tions made over the #ife ex%ectanc$ of the IAA owner Gontrib!tions ma$ not be made after the IAA owner t!rns age 81 P B even if he or she is sti## em%#o$ed @istrib!tions made over the #ife ex%ectanc$ of the IAA owner m!st begin no #ater than A%ri# 0 of the $ear fo##owing the $ear in which the owner t!rns age 81 P If a %erson fai#s to withdraw an$ amo!nt that sho!#d have been distrib!ted !nder these mandator$ minim!m re-!irements' a 513 tax %ena#t$ a%%#ies to the amo!nt not distrib!ted

*or more on how a traditiona# IAA wor"s' how to set one !% and even how to withdraw from it' review the t!toria# Traditional 3(,s.

.-ecial Issues for Retirement Plans - Roth IRAs

Aoth IAAs have a ver$ different tax str!ct!re than Traditiona# IAAs Gontrib!tions are notded!ctib#e .owever' earnings ma$ be withdrawn taxBfree (rather than taxBdeferred) if the fo##owing conditions are met& +ithdrawa#s do not occ!r !nti# the acco!nt has been o%en at #east five $ears AI@ +ithdrawa#s do not occ!r !nti# the Aoth IAA owner reaches age 52 P

The Aoth IAA is a ver$ %owerf!# vehic#e' since virt!a##$ a## other retirement acco!nts offer on#$ taxBdeferra# on the earnings .owever' income #imits do a%%#$ The chart be#ow shows the maxim!m amo!nt of income %ermitted to ma"e the f!## contrib!tion' as we## as the %haseBo!t income range for a %artia# contrib!tion&
Filing Status Single or Head of Household Married Filing Jointly Full Contribution Up to $95,000 Up to $150,000 Partial Contribution $95,001-$109,999 $150,001-$159,999

-he follo&ing information applies to >oth ">5s only7

Gontrib!tions are %ermitted after age 81 P (ass!ming there is earned income)

There are no mandator$ minim!m re-!ired distrib!tion r!#es at an$ age +ithdrawa#s are made on a *I*H basis (first in' first o!t) B so an$ withdrawa#s made come from contrib!tions first Therefore' no earnings are considered withdrawn !nti# a## contrib!tions have been withdrawn +ithdrawa#s of contrib!tions are neither taxab#e nor %ena#iCed B even if the$ are made before age 52 P or before the acco!nt has been o%en for five $ears +ithdrawa#s of earnings are taxed b!t not %ena#iCed !nder the same exce%tions #isted for Traditiona# IAAs

The Aoth IAA is arg!ab#$ the IAA with the most %otentia# There are man$ simi#arities between the Aoth and Traditiona# IAA b!t a#so some stri"ing differences The t!toria# onAoth Individ!a# Aetirement Acco!nt examines' how it wor"s' how to set one !%' and even how to withdraw from it

.-ecial Issues for Retirement Plans - Coverdell Education .avin%s Accounts

+hi#e other ed!cation savings acco!nts (s!ch as stateBs%onsored 572 %#ans) are not covered on the Series 66 exam' the Goverde##

ESA is tested *ormer#$ "nown as the Ed!cation IAA' it had been inc#!ded with other IAAs in the testing %rocess Therefore' basic -!estions abo!t the Goverde## are #i"e#$ to be fo!nd on the exam Da"e s!re $o! "now the fo##owing information&

Ann!a# contrib!tion #imit is /7'111' !% from the /511 #imit for the o#d Ed!cation IAA

This #imit is per student' so it is not %ossib#e for two sets of grand%arents to each contrib!te /7'111 to two different Goverde## ESAs for the same st!dent Io tax ded!ction is avai#ab#e for the contrib!tion' b!t earnings grow taxBdeferred +ithdrawa#s of earnings are taxBfree' if !sed for -!a#ified ed!cation ex%enses +ithdrawa#s of earnings not !sed for -!a#ified ed!cation ex%enses are taxed at the st!dentFs ordinar$ income tax rate and wi## a#so be s!b,ect to a 013 %ena#t$
Exam Tips and Tricks Consider these sample exam questions about IRAs:

1 ;hich of the follo&ing statements about -raditional ">5s are ->I9< " 6ontributions are allo&ed based on earned income only "" 6ontributions al&ays reduce ta1able income """ 6ontributions may be made even if the individual is covered by an employer*s retirement plan "V 6ontributions may not be made after age K0 L a b c d I ( II II' III ( I) I' III ( I) I' II' III ( I)

The correct answer is "c", since contributions may not reduce ta-able income if the person is not eligible to deduct the contribution. @ ;hich of the follo&ing clients is best suited for a >oth ">5

instead of a -raditional ">5< " Aomeone &ho is in a high ta1 brac0et no& and e1pects to be in a much lo&er ta1 brac0et in retirement "" Aomeone &ho is in a lo& ta1 brac0et no& and e1pects to be in a much higherta1 brac0et in retirement """ Aomeone &ho is covered by a retirement plan at &or0 and can only ma0e a non,deductible contribution to a -raditional ">5 because of a high income "V Aomeone &ho is in a moderate ta1 brac0et no& and e1pects to be in a lo&er ta1 brac0et in retirement a b c d I ( II II ( III II' III ( I) I' II' III ( I)

The correct answer is "b"# the (oth 3(, is the better choice for client 33, since the 3(, deduction is worth less to someone in a low bracket and the ta--free withdrawals will be more valuable to someone in a higher bracket. ,lso, it4s always better to make a non-deductible (oth 3(, contribution than a non-deductible Traditional 3(, contribution. The clients described in 3 and 35 e-pect to be in a lower ta- bracket at retirement, so they may be better off taking the ta- deduction now.

.-ecial Issues for Retirement Plans - Qualified Retirement Plans

If it meets certain criteria' a -!a#ified retirement %#an is %ermitted to ta"e advantage of s%ecia# tax treatment Hne "e$ re-!irement for -!a#ification is that the %#an m!st not discriminate in favor of the em%#o$erFs "e$ em%#o$ees The s%ecia# tax benefits inc#!de the fo##owing& The em%#o$er ma$ ta"e a tax ded!ction for contrib!tions made to

the %#an Em%#o$ees ma$ ta"e a tax ded!ction on their own contrib!tions to the %#an Earnings on a## contrib!tions are taxBdeferred !nti# withdrawn

*or a %rimer on the t$%es of -!a#ified retirement %#ans' the

t!toria# 6 1(k! and 7ualified )lans examines e#igibi#it$ re-!irements' contrib!tions' distrib!tions and other feat!res re#ated to each There are two t$%es of -!a#ified %#ans& defined benefit' and defined contrib!tion

1. 8efined Eenefit Plans @efined benefit %#ans are traditiona# %ension %#ans' where benefits are based on a s%ecific form!#a Dost form!#as !se the n!mber of $ears of service times a sa#ar$ factor (often an average of the highest three' or highest five' $ears of sa#ar$ histor$) An age factor is !sed as we##' so a wor"er retiring at 65 receives a higher month#$ benefit than one retiring at 67
8efined benefit plans have these characteristics7 o Em%#o$er ma"es a## contrib!tions o Em%#o$er ma"es a## investment decisions and bears the ris" if
o

investments %erform %oor#$ Less %o%!#ar since the rise of defined contrib!tion %#ans

7 8efined 6ontribution Plans Aather than basing %#an benefits on a s%ecific form!#a as defined benefit %#ans do'defined contrib!tion %#ans a##ocate mone$ to %#an %artici%ants based on a %ercentage of each em%#o$eeFs earnings The #onger the em%#o$ee %artici%ates in the %#an' the higher the acco!nt ba#ance grows' based on the amo!nts contrib!ted and the investment earnings Dost defined contrib!tion %#ans a##ow em%#o$ees to choose their own investment mix from the s%ecific f!nds made avai#ab#e thro!gh the em%#o$er 8efined contribution plans include the follo&ing7 o Profit,sharing planB This a##ows the em%#o$er to contrib!te a %ercentage of sa#ar$ each $ear' b!t the %ercentage can var$ each $ear based on cor%orate %rofits .owever' contrib!tions can be made even when there are no %rofits' at the em%#o$erFs discretion )01(0) plan , This form of %rofitBsharing %#an a##ows em%#o$ees to red!ce their taxab#e income b$ deferring a %ercentage of their sa#ar$ into the %#an

o o

)0H(b) plan B These %#ans are a#so "nown as taxBshe#tered ann!ities =oney purchase pension plan B This re-!ires the em%#o$er to contrib!te a set %ercentage of sa#ar$ each $ear regard#ess of cor%orate %rofits
Look Out! The main thing to know about the various defined contribution plans is that 403(b) plans are available only to employees of schools, hospitals and certain non-profit organizations. They are analogous to corporate 401(k) plans.

.-ecial Issues for Retirement Plans - Im-ortant ERI.A Issues

The Em%#o$ee Aetirement Income Sec!rit$ Act (EAISA) was enacted in 0289 to %rotect the rights of em%#o$ees !nder retirement %#ans offered b$ their em%#o$ers In addition to safeg!arding retirement f!nds from em%#o$er mismanagement' EAISA re-!irements a#so cover the fo##owing&

Fiduciary responsibility B The %#anFs tr!stee m!st manage %#an assets and ma"e decisions in the best interests of the %#an %artici%ants The tr!stee cannot se## assets to the %#an or earn commissions from %#an investments In addition' %#an assets m!st be "e%t segregated from com%an$ assets Aegarding investment o%tions !nder EAISA&
o o

*id!ciaries for the %#an m!st fo##ow the 5r!dent Investor standard S!fficient investment o%tions m!st be avai#ab#e !nder the %#an so that %#an %artici%ants can create an ade-!ate#$ diversified %ortfo#io An investment %o#ic$ statement is recommended to serve as a g!ide#ine for investment decisions to be made The statement ma$ inc#!de comments on ris" to#erance' investment %hi#oso%h$' time horiCons' asset c#asses and rate of ret!rn ex%ectations

Look Out! It is essential for an IA to understand investment policy statements. Either the plan participants or the plan trustees may sue an IA who does not follow the guidelines of this statement. The IA could be liable for breach of fiduciary duty, even if the plan assets have outperformed the market.

Don,discrimination B A## %#an %artici%ants m!st be treated e-!a##$ !nder the %#an' and high#$ com%ensated em%#o$ees m!st not benefit to a greater degree than em%#o$ees with #ower com%ensation

)esting B 5#an benefits ma$ re-!ire a vesting %eriod before the em%#o$ee earns the right to the benefit if he or she #eaves the com%an$ EAISA reg!#ations #imit the #ength of s!ch a vesting %eriod to a reasonab#e sched!#e

Iot a## em%#o$er %#ans are s!b,ect to EAISA *or exam%#e' governmenta# retirement %#ans are exem%t from EAISA re-!irements A#so' nonB -!a#ified %#ans' which do not -!a#if$ for taxBded!ctib#e contrib!tions' are not s!b,ect to EAISA These %#ans are disc!ssed in detai# in the within fo##owing section IAAs are not s!b,ect to EAISA' since an IAA is not considered an em%#o$er %#an

.-ecial Issues for Retirement Plans - !on-Qualified Retirement Plans

Un#i"e -!a#ified %#ans s!ch as defined benefit and defined contrib!tion %#ans' some %#ansare nonB-!a#ified' meaning the$ do not meet EAISA g!ide#ines and' therefore' the em%#o$er ma$ not ded!ct contrib!tions .owever' earnings on these %#ans are taxBdeferred !nti# withdrawn The most common nonB-!a#ified retirement %#ans are deferred com%ensation %#ans' which are set !% !nder IAS Gode Section 958 A 958 5#an is a t$%e of nonB-!a#ified' deferred com%ensation %#an estab#ished b$ state and #oca# governments' and taxBexem%t governments and em%#o$ers E#igib#e em%#o$ees are a##owed to ma"e sa#ar$ deferra#

contrib!tions Earnings grow on a taxBdeferred basis and contrib!tions are not taxed !nti# the assets are distrib!ted from the %#an Em%#o$ees are a##owed to defer !% to 0113 of com%ensation not exceeding the a%%#icab#e do##ar #imit for the $ear If the %#an does not meet stat!tor$ re-!irements' the assets ma$ be s!b,ect to different r!#es
Exam Tips and Tricks Consider these sample exam questions about retirement plans:

1 5 retirement plan is .ualified if it7 a is estab#ished b$ an em%#o$er instead of an individ!a# b -!a#ifies for s%ecia# tax treatment c %rovides s%ecia# benefits for high#$ %aid em%#o$ees d is %art of an IAA The correct answer is "b", since 8ualified plans must be established by the employer, but not all employer retirement plans are 8ualified. @ "f a retirement plan is non,.ualified, &hich one of the follo&ing statements is al&ays ->I97 a The %#an is i##ega# and sho!#d be terminated b Investment earnings acc!m!#ate taxBfree c The em%#o$er ma$ not ded!ct the %#an contrib!tions d It is a defined benefit %#an The correct answer is "c", since non-8ualified plans never permit deductibility of the employer4s contributions. H -he investment policy statement under a .ualified plan can best be described as7 a a re-!ired doc!ment that contains the K#ega# #istK of %ermissib#e investments in the %#an b a written doc!ment that o!t#ines the %#anFs investment ob,ectives and g!ide#ines c the #ist of %rohibited transactions that the fid!ciaries m!st not %ermit d a written doc!ment %rovided to the %#an %artici%ants' to #imit the tr!steesF #ega# #iabi#it$ for %oor investment decisions The correct answer is "b", since the document is designed to provide guidance on investment decisions, not give a list of re8uired or prohibited

investments.

CHAPTER 6: Portfolio Ris1s - Introduction

A c#ientFs idea of ris" is !s!a##$ #imited to concerns abo!t mar"et ris" Gonse-!ent#$' there are man$ different t$%es of investment ris" and IAs sho!#d !nderstand them a## In addition' IAs sho!#d "now how to meas!re ris" and devise strategies to %rotect c#ients The t!toria#' (isk and 'iversification examines the different t$%es of ris"' the ris"<ret!rn tradeoff' and diversification

Portfolio Ris1s - 'ond Ris1s

+hi#e more %!b#icit$ is given to ris" in the stoc" mar"ets' there are a n!mber of ris"s associated with investing in bonds&

Ga## ris" B +hen interest rates fa##' a ca##ab#e bond is more #i"e#$ to be ca##ed in' and the investor wo!#d have to re%#ace it with a #owerB co!%on bond

Aeinvestment ris" B This can refer to reinvestment of %rinci%a# after a bond is ca##ed' as we## as reinvestment of the dividends from a highBco!%on bond into a #owerBrate investment Gredit ris" B This refers to the %ossibi#it$ that the bond iss!er wi## not be ab#e to ma"e ex%ected interest rate %a$ments and<or %rinci%a# re%a$ment Interest rate ris" B If interest rates rise' the mar"et va#!e of the bond wi## dec#ine This is #ess of an iss!e if the investor can ho#d the bond !nti# it mat!res Purchasing po&er ris0 B A#so "nown as inf#ation ris"' this refers to the ver$ rea# %ossibi#it$ that as inf#ation increases the %!rchasing %ower of the bond income wi## decrease Li-!idit$ ris" B This refers to the mar"etabi#it$ of the bond Gertain iss!ers ma$ be #ess mar"etab#e than others Event ris" B An$ n!mber of events can affect the creditBworthiness of the iss!er Leveraged b!$o!ts' cor%orate restr!ct!rings' mergers and ac-!isitions' and ban"r!%tcies can a## have a negative im%act

on a bondFs %rice ?pportunity cost ris0 B This refers to the %otentia##$ higher rate of ret!rn an investor co!#d earn if the mone$ !sed to %!rchase a bond were %#aced in an a#ternate investment G!rrenc$ ris" B A#so "nown as exchange ris"' this ris" a%%#ies on#$ to foreign bonds

>efore we de#ve into d!ration' the %rimar$ meas!re of bond ris"' we recommend a read of the fo##owing t!toria#s If the to%ic of bonds is !nfami#iar to $o!' or $o! need a br!sh !% on their basics' see o!r 9ond 9asics T!toria# If $o! are fair#$ fami#iar with bonds' move on to o!r ,dvanced 9ond Tutorial ' which foc!ses on bond f!ndamenta#s s!ch %ricing' $ie#d' and d!ration Iote that the inc#!sion of these t!toria#s is so $o! better !nderstand the conce%t of d!ration =o! wi## most #i"e#$ not be as"ed bondBs%ecific -!estions on $o!r Series 66 exam (=o! wi## need to "now this materia# for $o!r Series 8 exam' however)

Portfolio Ris1s - 7uration and .toc1 Ris1s

8uration The %rimar$ meas!re of bond %rice vo#ati#it$ is d!ration It ta"es into acco!nt both the #ength of time to mat!rit$ and the difference between the co!%on rate and the $ie#d to mat!rit$ .ere are some of the most im%ortant facts abo!t d!ration&

The #onger the d!ration of a %artic!#ar bond' the more its %rice wi## f#!ct!ate in res%onse to interest rate changes

@!ration is a#wa$s e-!a# to or #ess than the $ears to mat!rit$ of the bond @!ration can he#% to ca#c!#ate the im%act of interest rate changes on the %rice of the bond *or exam%#e' a bond with a d!ration of O is #i"e#$ to decrease O3 for ever$ 011 basis %oints increase in mar"et interest rates

@!ration is a weighted average term to mat!rit$ As %a$ment fre-!enc$ increases' d!ration decreases
Exam Tips and Tricks A zero-coupon bond, with only one payment (at the end of the term), has the highest duration of any bond and is therefore the most sensitive to price changes due to interest rate changes.

Atoc0 >is0s .ere are some ris"s associated with investing in the stoc" mar"ets&

S$stematic ris" B A#so "nown as mar"et ris"' this is the %otentia# for the entire mar"et to dec#ine S$stematic ris" cannot be diversified awa$

Uns$stematic ris" B This is the ris" that an$ one stoc" ma$ go down in va#!e' inde%endent of the stoc" mar"et as a who#e This ris" ma$ be minimiCed thro!gh diversification This a#so incor%orates b!siness ris" and event ris" (as described in the K>ond Ais"sK section) >!siness ris"B The ris" that a com%an$ wi## not ma"e eno!gh mone$ to sta$ in b!siness >egulatory ris0 B The ris" that #aws ma$ change and im%act the b!siness' ind!str$ or governmenta# entit$' th!s having an im%act on the va#!e of the sec!rit$ ?ther ris0s , H%%ort!nit$ ris" and #i-!idit$ ris" (both described in the K>ond Ais"sK section) ma$ a#so a%%#$ to stoc"s in a %ortfo#io

Portfolio Ris1s - Measurin% Portfolio Ris1s

Hne of the conce%ts !sed in ris" and ret!rn ca#c!#ations is standard deviation' which meas!res the dis%ersion of act!a# ret!rns aro!nd the ex%ected ret!rn of an investment Since standard deviation is the s-!are root of the variance' variance is another cr!cia# conce%t to "now The variance is ca#c!#ated b$ weighting each %ossib#e dis%ersion b$ its re#ative %robabi#it$ (ta"e the difference between the act!a# ret!rn and the ex%ected ret!rn' then s-!are the n!mber)

The standard deviation of an investmentFs ex%ected ret!rn is considered a basic meas!re of ris" If two %otentia# investments had the same ex%ected ret!rn' the one with the #ower standard deviation wo!#d be considered to have #ess %otentia# ris" >is0 measures There are three other ris" meas!res !sed to %redict vo#ati#it$ and ret!rn&

>eta , This meas!res stoc" %rice vo#ati#it$ based so#e#$ on genera# mar"et movements T$%ica##$' the mar"et as a who#e is assigned a beta of 0 1 So' a stoc" or a %ortfo#io with a beta higher than 0 1 is %redicted to have a higher ris" and' %otentia##$' a higher ret!rn than the mar"et Gonverse#$' if a stoc" (or f!nd) had abeta of O5' this wo!#d indicate that if the mar"et increased b$ 013' this stoc" (or f!nd) wo!#d #i"e#$ ret!rn on#$ O 53 .owever' if the mar"et dro%%ed 013' this stoc" wo!#d #i"e#$ dro% on#$ O 53 Learn how to %ro%er#$ !se this meas!re to he#% $o! meet $o!r criteria for ris" within the artic#e 9eta# :auging )rice +luctuations

A#%ha , This meas!res stoc" %rice vo#ati#it$ based on the s%ecific characteristics of the %artic!#ar sec!rit$ As with beta' the higher the n!mber' the higher the ris"

Alpha = [(sum of y) - ((b)(sum of x))]n Where: n = number of observations (36 months) b = beta of the fund x = rate of return for the market y = rate of return for the fund

An a#%ha of 0 1 means the f!nd o!t%erformed the mar"et 03 Shar%e ratio , This is a more com%#ex meas!re that !ses the standard deviation of astoc" or %ortfo#io to meas!re vo#ati#it$ This ca#c!#ation meas!res the incrementa# reward of ass!ming incrementa# ris" The #arger the Shar%e ratio' the greater the %otentia# ret!rn

Sharpe Ratio = (total return - risk free rate of return) M

Look Out! The reverse of "the larger the Sharpe ratio, the greater the return" also holds true. The "lower the Sharpe ratio, the lower the potential return". If a security\'s Sharpe ratio were equal to "0", there would be no reward for taking on the higher risk, and the investor would be better off simply holding Treasuries (whose return is equal to the risk-free return component of the equation).

Portfolio Ris1s - .toc1 Ris1 Reduction .trate%ies

Jiven the ris"s o!t#ined above' an IA can ta"e advantage of the fo##owing ris" red!ction strategies to he#% %rotect his or her c#ientsF %ortfo#ios&

@iversification B @iversification refers to investing in a s!fficient n!mber of different iss!es to minimiCe s$stematic (mar"et) ris" It is a#so disc!ssed in the 5ortfo#io Danagement Strategies section as %art of the asset a##ocation %rocess' where it refers to the %rocess of investing in different t$%es of sec!rities' s!ch as stoc"s of both #arge and sma## com%anies' or bonds from both cor%orate and government iss!ers

@o##arBcost averaging (@GA)B This strateg$ ca##s for a fixed do##ar amo!nt to be invested in the shares of a stoc" or m!t!a# f!nd on a %eriodic basis (t$%ica##$ month#$ or -!arter#$) Therefore' the investor receives more shares when the sec!rit$ %rice is #ower and fewer shares when the sec!rit$ %rice is higher Ass!ming share %rices f#!ct!ate d!ring the investment %eriod' the end res!#t is a #ower overa## cost %er share over time @GA offers %rotection and o%%ort!nit$ in a sin"ing mar"et The artic#e '%,# 3t :ets ;ou in at the 9ottom ex%#ains how "ncome reinvestment , Interest and dividends from stoc"s as we## as a## t$%es of m!t!a# f!nds ma$ end !% sitting in a mone$ mar"et acco!nt earning ver$ #ow interest !nti# an amo!nt

s!fficient#$ #arge to be invested acc!m!#ates A better strateg$ is to set !% a!tomatic income reinvestment %rograms #i"e the fo##owing&

=utual fund reinvestment , +hen investing in m!t!a# f!nds' $o! can set dividends and<or ca%ita# gains to be a!tomatica##$ reinvested in additiona# shares

@ividend reinvestment %#ans (@AI5S)B A %#an offered b$ a cor%oration that a##ows investors to reinvest their cash dividends b$ %!rchasing additiona# shares or fractiona# shares on the dividend %a$ment date Learn more abo!t the %er"s of @AI5S within the artic#e& The )erks of 'ividend (einvestment )lans
Exam Tips and Tricks Consider these sample exam questions:

1 5n investor o&ns a small,cap stoc0 &ith very lo& trading volume -he investor has a high level of7 a b!siness ris" b mar"et ris" c #i-!idit$ ris" d %!rchasing %ower ris" The correct answer is "c" - while there is also the potential of business risk, the best answer is li8uidity risk because the 8uestion focuses on the low trading volume. @ 5ssuming that prices fluctuate throughout the investing period, the use of dollar,cost averaging results in a7 a #ower average cost %er share b higher average cost %er share c #ower mar"et %rice %er share d higher mar"et %rice %er share The correct answer is "a"# when prices are lower, more shares are bought, which results in a lower average cost per share.