Question 1

One of the first steps an investor should take is to establish the objectives of the portfolio.

Accepted Answer

Establishing the objectives of the portfolio is crucial as it guides the investment strategy, risk tolerance, and asset allocation, aligning investments with the investor's goals and financial situation.

Question 2

The tendency of investors to follow a "herd" mentality helps explain financial bubbles.

Accepted Answer

Herd mentality in investing refers to investors following the actions of a larger group, often leading to overvaluation and financial bubbles as people buy into rising assets without considering their intrinsic value.

Question 3

In an efficient securities market, the investor cannot earn, over a period of years, a return comparable to the amount of risk the individual bears.

Accepted Answer

In an efficient securities market, prices reflect all available information, so investors can earn returns commensurate with the level of risk they take on. Higher risk investments typically offer the potential for higher returns to compensate for the increased risk.

Question 4

For diversification to reduce risk,
A)the returns on the individual securities should be highly correlated
B)the prices of the stocks should be stable
C)the returns on the individual securities should be negatively correlated
D)one firm should offer dividends and the other should offer capital gains

Accepted Answer

Diversification reduces risk by combining assets that do not move in the same direction; when the returns on individual securities are negatively correlated, losses in one can be offset by gains in another, thereby reducing overall portfolio risk.

Question 5

The process of financial planning requires the individual to
1. establish financial goals and objectives
2. identify and quantify the value of his or her assets
3. hire professional financial advisors
A)1 and 2
B)1 and 3
C)2 and 3
D)all of the above

Accepted Answer

Financial planning involves establishing financial goals and objectives, and identifying and quantifying the value of assets. Hiring professional financial advisors is not a requirement for the process, although it can be beneficial.

Question 6

If financial markets are efficient, that negates the importance of financial planning.

Accepted Answer

Efficiency in financial markets means that prices reflect all available information, but financial planning is still crucial for individual goals, risk management, and long-term financial health, regardless of market efficiency.

Question 7

Diversification reduces
A)systematic risk
B)unsystematic risk
C)market risk
D)purchasing power risk

Accepted Answer

Diversification is a strategy used to reduce unsystematic risk, which is the risk associated with individual assets. It does not reduce systematic risk, market risk, or purchasing power risk, as these are inherent to the entire market or economy and cannot be mitigated through diversification.

Question 8

Portfolio risk encompasses
1. a firm's financing decisions
2. interest rate risk
3. loss of purchasing power
A)1 and 2
B)1 and 3
C)2 and 3
D)all of the above

Accepted Answer

Portfolio risk can include a variety of factors such as a firm's financing decisions, which can affect the risk profile of investments held; interest rate risk, which impacts the value of fixed-income investments as rates change; and loss of purchasing power, which refers to the risk that inflation will erode the real value of assets over time.

Question 9

If the financial markets were not efficient,
A)all investors would profit
B)prices indicate the proper valuation of securities
C)prices would adjust rapidly
D)an investor may consistently outperform the market

Accepted Answer

In inefficient financial markets, information is not immediately or fully reflected in security prices, allowing some investors to consistently outperform the market by exploiting this inefficiency.

Question 10

If an investor believes that financial markets are inefficient, that argues for the individual to pursue a more active portfolio strategy.

Accepted Answer

If an investor believes that financial markets are inefficient, they may think that securities can be mispriced, which creates opportunities for active management to select securities that are undervalued or to avoid those that are overvalued, aiming to achieve better returns than passive strategies.

Question 11

In a well-diversified portfolio, the risk associated with fluctuations in securities prices (i.e., the market)is reduced.

Accepted Answer

In a well-diversified portfolio, unsystematic risk (specific to individual securities) is reduced, but systematic risk (market risk) cannot be eliminated through diversification.

Question 12

Price bubbles may be evidence that
1. financial markets are inefficient
2. financial markets are rational
3. the investors have a herd instinct
4. investors do not have a herd instinct
A)1 and 3
B)1 and 4
C)2 and 3
D)2 and 4

Accepted Answer

Price bubbles often indicate market inefficiency, as prices deviate from their true value based on irrational investor behavior, including herd instinct, where investors follow the majority without independent analysis.

Question 13

Possible investment objectives may include
1. capacity to meet financial emergencies
2. preservation of capital
3. desire to finance retirement
A)1 and 2
B)1 and 3
C)2 and 3
D)all of the above

Accepted Answer

All listed options (capacity to meet financial emergencies, preservation of capital, and desire to finance retirement) are common investment objectives, indicating that all of the above is the correct choice.

Question 14

Asset allocation is important to help diversify a portfolio but has little impact on the portfolio's return.

Accepted Answer

Asset allocation is crucial not only for diversification but also significantly impacts a portfolio's return by determining the mix of asset classes (stocks, bonds, cash, etc.) that align with the investor's risk tolerance, investment goals, and time horizon, thus affecting the portfolio's overall performance.

Question 15

Even if financial markets have elements of inefficiency, the individual may still be unable to outperform the market.

Accepted Answer

Even with market inefficiencies, individual investors may lack the information, skill, or resources to exploit these inefficiencies and outperform the market consistently.

Question 16

An active portfolio strategy is premised on
A)the stock market being efficient
B)the stock market being inefficient
C)the investor's being able to obtain public information
D)the portfolio manager's access to corporate management

Accepted Answer

An active portfolio strategy operates on the premise that the stock market is inefficient, allowing investors to identify undervalued or overvalued stocks through analysis to achieve higher returns.

Question 17

Since virtually all investments involve risk, the individual should develop a diversified portfolio.

Accepted Answer

Diversification helps to spread out investment risk across different types of assets, reducing the impact of a poor performance in any single investment on the overall portfolio.

Question 18

Sources of risk include
1. fluctuating exchange rates
2. a firm's financing decisions
3. higher interest rates
4. loss of purchasing power
A)1 and 2
B)2 and 3
C)2 and 4
D)all four

Accepted Answer

All four options are sources of risk. Fluctuating exchange rates can affect the value of foreign investments, a firm's financing decisions can impact its leverage and financial stability, higher interest rates can increase borrowing costs, and loss of purchasing power due to inflation can erode real returns.

Question 19

If financial markets are efficient, that suggests that
A)investors cannot earn superior returns
B)investors cannot expect to outperform the market consistently
C)security prices are random
D)bearing additional risk will not increase return

Accepted Answer

In an efficient market, all available information is already reflected in security prices, making it difficult for investors to consistently outperform the market.

Question 20

While the investor is able to reduce asset-specific risk, other sources of risk remain.

Accepted Answer

Diversification can reduce asset-specific risk (also known as unsystematic risk), but market risk (systematic risk), which affects all investments, remains.

Quiz 20: Financial Planning and Investing in an Efficient Market Context

One of the first steps an investor should take is to establish the objectives of the portfolio.

The tendency of investors to follow a "herd" mentality helps explain financial bubbles.

In an efficient securities market, the investor cannot earn, over a period of years, a return comparable to the amount of risk the individual bears.

For diversification to reduce risk,

The process of financial planning requires the individual to 1. establish financial goals and objectives 2. identify and quantify the value of his or her assets 3. hire professional financial advisors

If financial markets are efficient, that negates the importance of financial planning.

Diversification reduces

Portfolio risk encompasses 1. a firm's financing decisions 2. interest rate risk 3. loss of purchasing power

If the financial markets were not efficient,

If an investor believes that financial markets are inefficient, that argues for the individual to pursue a more active portfolio strategy.

In a well-diversified portfolio, the risk associated with fluctuations in securities prices (i.e., the market)is reduced.

Price bubbles may be evidence that 1. financial markets are inefficient 2. financial markets are rational 3. the investors have a herd instinct 4. investors do not have a herd instinct

Possible investment objectives may include 1. capacity to meet financial emergencies 2. preservation of capital 3. desire to finance retirement

Asset allocation is important to help diversify a portfolio but has little impact on the portfolio's return.

Even if financial markets have elements of inefficiency, the individual may still be unable to outperform the market.

An active portfolio strategy is premised on

Since virtually all investments involve risk, the individual should develop a diversified portfolio.

Sources of risk include 1. fluctuating exchange rates 2. a firm's financing decisions 3. higher interest rates 4. loss of purchasing power

If financial markets are efficient, that suggests that

While the investor is able to reduce asset-specific risk, other sources of risk remain.