CFP Investment Planning & Portfolio Management 1 — Questions and Answers
Question 1: What does 'standard deviation' measure in portfolio analysis?
- The average return of a portfolio over time
- The total risk of a portfolio, measuring the dispersion of returns around the mean (Correct answer)
- The correlation between two asset classes
- The downside risk only, ignoring positive returns
Correct answer: The total risk of a portfolio, measuring the dispersion of returns around the mean
Standard deviation measures total risk by quantifying how widely a portfolio's returns are dispersed around its average return.
Question 2: According to Modern Portfolio Theory (MPT), what is the primary benefit of diversification?
- It guarantees positive returns in all market conditions
- It eliminates all investment risk
- It reduces portfolio risk without necessarily sacrificing expected return by combining assets with low correlations (Correct answer)
- It maximizes portfolio returns by concentrating in the best-performing asset class
Correct answer: It reduces portfolio risk without necessarily sacrificing expected return by combining assets with low correlations
MPT demonstrates that combining assets with low or negative correlations can reduce portfolio risk (standard deviation) while maintaining expected return levels.
Question 3: What does the Sharpe Ratio measure?
- The total return of a portfolio over a benchmark
- The risk-adjusted return of a portfolio, calculated as excess return per unit of total risk (Correct answer)
- The correlation between a portfolio and a market index
- The maximum drawdown a portfolio has experienced
Correct answer: The risk-adjusted return of a portfolio, calculated as excess return per unit of total risk
The Sharpe Ratio measures risk-adjusted performance by dividing the portfolio's excess return (above the risk-free rate) by its standard deviation.
Question 4: What is 'beta' in the context of portfolio management?
- A measure of a stock's total risk relative to its own historical returns
- A measure of systematic risk that indicates how sensitive an investment is to market movements (Correct answer)
- The expected return of a portfolio as calculated by the CAPM
- The ratio of fixed income to equity in a portfolio
Correct answer: A measure of systematic risk that indicates how sensitive an investment is to market movements
Beta measures an investment's sensitivity to market movements; a beta of 1.0 means the investment moves in line with the market, while >1.0 indicates higher volatility.
Question 5: Which of the following best describes dollar-cost averaging (DCA)?
- Investing a lump sum all at once to maximize time in market
- Investing a fixed dollar amount at regular intervals regardless of market price (Correct answer)
- Rebalancing a portfolio to target allocations annually
- Selecting investments based on their current price-to-earnings ratio
Correct answer: Investing a fixed dollar amount at regular intervals regardless of market price
Dollar-cost averaging involves investing a consistent dollar amount at regular intervals, automatically buying more shares when prices are low and fewer when prices are high.
Question 6: What is the efficient market hypothesis (EMH) and which form suggests that technical analysis cannot consistently produce excess returns?
- Strong form, which holds that all public and private information is reflected in prices
- Semi-strong form, which holds that all publicly available information is already priced in
- Weak form, which holds that past price and volume data cannot predict future prices (Correct answer)
- All three forms equally support this conclusion
Correct answer: Weak form, which holds that past price and volume data cannot predict future prices
The weak form of EMH asserts that all historical price and trading volume data is already reflected in current prices, making technical analysis unable to consistently generate alpha.
CFP Investment Planning & Portfolio Management 1
What does 'standard deviation' measure in portfolio analysis?