CFP Investment Planning Practice Questions
Question 1
A stock has a beta of 1.3. This means the stock's returns are expected to be:
- A. Uncorrelated with the overall market
- B. About 1.3 times as volatile as the overall market due to systematic risk
- C. 30% less volatile than the risk-free rate
- D. A measure of the stock's total risk, including company-specific risk and market risk
Show answer and explanation
Correct answer: B. About 1.3 times as volatile as the overall market due to systematic risk
Beta measures a security's sensitivity to overall market movements — a beta of 1.3 implies the stock tends to move about 1.3 times as much as the market in the same direction, reflecting greater-than-market systematic risk. Beta says nothing about correlation being zero, has no direct relationship to the risk-free rate, and specifically excludes unsystematic (company-specific) risk, which is measured instead by the residual/unexplained variance or captured in standard deviation.
- A. Wrong — a beta of 1.3 indicates a strong positive relationship with the market, the opposite of being uncorrelated.
- B. Correct — beta measures sensitivity to systematic (market) risk, so a beta of 1.3 implies returns that move about 30% more than the market in the same direction.
- C. Wrong — beta relates a stock's volatility to the overall market's movement, not to the risk-free rate, and 1.3 indicates greater, not lesser, volatility.
- D. Wrong — beta captures only systematic (market) risk; it excludes unsystematic, company-specific risk, so it is not a measure of total risk, which standard deviation of total returns would capture.
Question 2
An investor commits to investing a fixed dollar amount into a mutual fund every month, regardless of share price. Which outcome is a direct mathematical result of this dollar-cost averaging strategy, assuming the share price fluctuates over the period?
- A. The investor is assured of a profit on the shares purchased, because a lower average cost per share means the final price must exceed that cost
- B. The investor removes exposure to market declines on the shares purchased, because spreading purchases over time protects the account balance from falling prices, even in a prolonged falling market
- C. The investor buys the same number of shares each period, so the average cost per share equals the simple average of the prices paid across the periods
- D. The investor's average cost per share will generally be lower than the simple average of the share prices paid, because more shares are purchased when prices are lower
Show answer and explanation
Correct answer: D. The investor's average cost per share will generally be lower than the simple average of the share prices paid, because more shares are purchased when prices are lower
Because a fixed dollar amount buys more shares when prices are low and fewer shares when prices are high, the resulting average cost per share is mathematically lower than or equal to the simple arithmetic average of the prices paid across periods. It does not guarantee a profit or eliminate market risk.
- A. Wrong — a lower average cost does not assure a profit; if the price at the end of the period is below the average cost, the investor still has a loss.
- B. Dollar-cost averaging manages timing risk but does not eliminate market risk — the investor is still fully exposed to price declines, including in a prolonged falling market.
- C. Wrong — a fixed dollar amount buys more shares when prices are low and fewer when prices are high, so the share count changes each period and the average cost falls below the simple average price.
- D. Correct. Because a fixed dollar amount buys more shares when prices are low and fewer when prices are high, the resulting average cost per share is generally below the simple average of the prices paid.
Question 3
Two retirees experience the same 20-year arithmetic average return. One has steep losses in the first two years while withdrawing a fixed inflation-adjusted amount; the other has losses late in retirement. What is the key risk to evaluate?
- A. The first retiree has a higher long-term geometric return because early losses are offset by larger gains later in the retirement period.
- B. Sequence risk affects the second retiree more, since late-retirement losses apply to a larger balance and leave less time to adjust spending.
- C. Return order matters little when annual withdrawals are fixed, because the same average return produces the same ending balance in either case.
- D. Early negative returns combined with withdrawals can irreversibly deplete capital before recovery.
Show answer and explanation
Correct answer: D. Early negative returns combined with withdrawals can irreversibly deplete capital before recovery.
Withdrawals during early drawdowns force sales at depressed prices, reducing the capital left to compound in a recovery. Identical average returns do not produce identical outcomes when withdrawals are taken.
- A. The same set of returns in any order has the same geometric return; order changes outcomes only because of withdrawals.
- B. Sequence risk is greatest early in the withdrawal phase, when losses hit the full balance and withdrawals lock them in.
- C. With ongoing withdrawals, order strongly affects ending balance even when average returns are identical.
- D. Correct: early losses plus withdrawals can deplete capital before markets recover.
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A retiree holds a large position in long-term fixed-rate bonds and short-term CDs as her primary source of retirement income over an expected 20-year retirement. Which risk is she most exposed to, and which strategy is generally best suited to help mitigate it?
- A. Reinvestment risk; mitigated by shifting the portfolio into zero-coupon bonds that do not pay periodic interest requiring reinvestment
- B. Liquidity risk; mitigated by extending the portfolio into additional long-term CDs that pay higher stated interest rates over time
- C. Default risk; mitigated by moving the entire portfolio into short-term U.S. Treasury bills backed by the full faith and credit of the federal government, which removes issuer failure risk
- D. Purchasing power (inflation) risk; mitigated by including growth-oriented assets such as equities or inflation-linked securities (e.g., TIPS) in the portfolio
Show answer and explanation
Correct answer: D. Purchasing power (inflation) risk; mitigated by including growth-oriented assets such as equities or inflation-linked securities (e.g., TIPS) in the portfolio
A portfolio concentrated in fixed-rate instruments with income that does not adjust for inflation exposes a long-horizon retiree to purchasing power risk — the erosion of real income and principal value over time as the cost of living rises. Over a 20-year retirement, even modest inflation compounds substantially. Mitigation generally requires an allocation to assets whose returns can outpace inflation over time, such as equities, or securities explicitly indexed to inflation, such as TIPS. Reinvestment and default risk are real but secondary concerns here; more long-term CDs would actually worsen purchasing power risk, not improve liquidity in a meaningful way for this concern.
- A. Wrong — reinvestment risk is not the main threat over a 20-year retirement funded by fixed-rate holdings; the bigger danger is inflation eroding purchasing power, and zero-coupon bonds do nothing to address that.
- B. Wrong — liquidity risk is not the central issue here, and adding longer-term CDs at higher stated rates would not protect purchasing power over two decades.
- C. Wrong — default risk isn't the primary concern in this scenario, and shifting entirely to T-bills, even though they carry little issuer failure risk, would worsen, not fix, the inflation exposure.
- D. Correct — a portfolio concentrated in fixed-rate bonds and short-term CDs is highly exposed to purchasing power (inflation) risk over a long retirement, best mitigated by adding growth assets like equities or inflation-linked securities such as TIPS.