File: ch01, Chapter 1: UNDERSTANDING INVESTMENTS

Type: Multiple Choice

1. Which of the following is not considered an investment?

a. The commitment of funds to an asset held for the future

b. Gold coins
c. Treasury notes
d. Renting an apartment

Ans: d
Difficulty: Easy
Response: Investments can be real (gold), or financial (Treasury notes), marketable or
non-marketable, but all are expected to have some value in the future.
Ref: Establishing a Framework for Investing

2. Which of the following is not a common reason why people invest in financial
assets?

a. Save for retirement

b. Save to buy a house or condominium
c. Save for children’s education
d. Help their stockbroker make commissions

Ans: d
Difficulty: Easy
Response: Although many financial companies do encourage us to invest with them, the
rational reason that people invest is to increase their wealth and their ability to buy goods
and services, like a home, an education, or to fund one’s retirement.
Ref: Establishing a Framework for Investing

3. Which of the following best describes 401K investment plans?

a. 401Ks are defined benefit plans offered by many employers.

b. 401Ks allow the worker to make his own investment choices.
c. 401Ks are guaranteed by an agency of the U.S. government.
d. 401Ks must be invested in very safe investments, like government bonds.

Ans: b
Difficulty: Medium
Response: 401K plans are defined contribution plans offered by many private employers,
where the employee chooses where to invest his contributions and any matching
contribution that the employer may provide.
Ref: The Importance of Studying Investments
4. Which of the following is not a career that requires an understanding of
investments?

a. Investment bankers
b. Bond brokers
c. Chemical engineers
d. Registered representatives

Ans: c
Difficulty: Easy
Response: The study of investments prepares people for careers as investment bankers,
bond traders and salespeople, security analysts, portfolio managers, registered
representatives, and financial planners, but not chemical engineers.
Ref: The Importance of Studying Investments

5. Which of the following is the foundation for making investment decisions?

a. Buying the right investment products

b. The trade-off between expected return and risk
c. Making the highest rate of return
d. Minimizing taxes, commissions and storage costs

Ans: b
Difficulty: Difficult
Response: Maximizing expected return is important, but only once we have considered
risk. We can only know which investment products are “right” after defining our goals –
maximize expected return for a specified level of risk. Taxes, commissions, and similar
transaction costs can be significant, but must be considered part of expected return.
Ref: Understanding the Investment Decision Process

6. On average, what asset class tends to have the highest risk?

a. Savings accounts
b. U.S. Treasury bonds
c. Corporate high yield (aka “Junk”) bonds
d. Common stocks

Ans: d
Difficulty: Difficult
Stocks tend to have higher expected returns than savings accounts or bonds. Higher
expected return is compensation to investors for taking on higher risk. Stocks stand last
in priority, even after junk bonds.
Ref: Understanding the Investment Decision Process
7. Ex ante investment returns are derived based on:

a. probabilities of outcomes and returns earned in those outcomes.

b. each possible return having an equal chance of occurring.
c. measuring returns over some lengthy period of time.
d. the recent returns that have been earned.

Ans: a
Difficulty: Medium
Response: Ex ante returns refer to “before the fact” expected returns, whereas ex poste
returns refer to “after the fact” realized returns. Ex ante returns are derived by
multiplying return probabilities times the outcomes’ returns and summing.
Ref: Understanding the Investment Decision Process

8. Which of the following is considered an “investment,” but not a “marketable

security?”

a. A common stock
b. An apartment building
c. A Treasury bond
d. An exchange traded fund (ETF)

Ans: b
Difficulty: Easy
Response: An investment in an apartment building is considered an investment in a “real”
asset, not a “financial” asset. Stocks, bonds and funds are considered “financial assets,”
making them liquid, tradeable investments, i.e. marketable securities.
Ref: Establishing a Framework for Investing

9. Which of the following investment professionals is responsible for selling mutual

funds and other investment products to individual investors?

a. Portfolio manager
b. Investment banker
c. Security analyst
d. Financial advisor

Ans: d
Difficulty: Medium
Response: Portfolio managers are responsible for making the buy/sell decisions in a
portfolio of securities. Investment bankers assist with mergers and acquisitions, as well as
arranging the sale of new securities to institutional investors. A security analyst, or
investment analyst, may assist investment bankers or portfolio managers by providing a
valuation of a company and its securities. Financial advisors primarily sell stocks, bonds
and funds to individual investors.
Ref: The Importance of Studying Investments
10. Which of the following is a reason that studying investments is more important
now than in previous generations?

a. More college business programs require students to take an investments course.

b. Workers are increasingly responsible for managing their own retirement funds.
c. The Securities and Exchange Commission now requires would-be investors to
pass a test on investment basics.
d. The stock market crash in 2008 highlights the risks inherent in investing.

Ans: b
Difficulty: Easy
Response: More and more employees will be responsible for managing their own
retirement funds in 401K and other retirement plans.
Ref: The Importance of Studying Investments

11. What is meant by the statement “investors are risk averse”?

a. Investors never invest in assets with high levels of risk.

b. Investors invest in risky assets only if they expect a greater return.
c. All investors choose risky assets.
d. All investors will choose to invest in the same assets.

Ans: b
Difficulty: Difficult
Response: Investors are considered risk-averse because they will only accept an increased
level of risk if they feel that the expected return of the investment will adequately
compensate them for that risk. In other words, a risk-averse investor will not take risk
without reward.
Ref: Understanding the Investment Decision Process

12. Which of the following is a defined benefit retirement account sponsored by an

employer?

a. 401K plan
b. IRA (Individual Retirement Account)
c. Pension plan
d. Mutual fund

Ans: c
Difficulty: Difficult
Response: A 401K plan is a defined “contribution” retirement account sponsored by an
employer, where the employee chooses investments, and the employer often matches the
employee’s contributions. An IRA is a self-directed retirement account, not typically
sponsored by an employer. A mutual fund refers to the underlying investments, which are
typically owned in a 401K or IRA retirement account.
Ref: The Importance of Studying Investments
13. If investors are risk-averse, then what is meant by the term “risk tolerance”?

a. Risk tolerance is the opposite of risk-aversion.

b. Risk tolerance refers to the degree of risk an investor is willing to accept with
their investments.
c. Risk tolerance is the same as risk-aversion.
d. Risk tolerance is the same for all investors.

Ans: b
Difficulty: Difficult
Response: Risk tolerance reflects the degree to which an investor is willing to accept risk
in their investment portfolio, based on their own particular set of circumstances. A 27-
year old professional with no dependents and a six-figure income may have a higher risk
tolerance than a 75-year old retiree who needs stable investment income to pay bills.
Ref: Understanding the Investment Decision Process

14. Why is the risk-return tradeoff line upward sloping?

a. The definition of “risk averse” implies that people will accept more risk
(horizontal axis) only if they get more expected return (vertical axis).
b. The line has to slope upward because all investors hold the market portfolio.
c. All investments on the line will return the risk-free rate.
d. Because investors prefer to invest in riskier securities.

Ans: a
Difficulty: Medium
Response: The line is upward sloping because as risk increases, expected return must
increase. Otherwise, no risk-averse investor would accept any risk greater than the risk-
free rate.
Ref: Some Practical Advice

15. Among the following assets, which is the most risky?

a. Corporate bonds
b. Treasury bonds
c. Speculative puts & calls
d. Corporate equities

Ans: c
Difficulty: Easy
Response: Treasury bonds, corporate bonds and corporate equities have less risk, i.e.
variability in returns, than stock options like puts and calls. Options are derivative
securities, which when held individually, can carry a great deal of price volatility, and
therefore risk.
Ref: Some Practical Advice
16. Why do many investors invest large amounts in risky tech stocks?

a. The stocks are considered relatively low risk due to the new economy.
b. The investors have very low risk tolerance.
c. The investors have relatively high risk tolerance.
d. The investors are misled by unscrupulous financial advisors.

Ans: c
Difficulty: Medium
Response: The late 1990’s saw investors bid up even the most speculative of technology
stocks, a period of time in the stock markets now commonly referred to as the “Tech
Bubble,” or “Internet Bubble.” With record returns in stocks during that period, many
investors increased their risk tolerance to continue chasing returns in technology stocks in
particular. A similar situation occurred during the early through mid-2000’s.
Unfortunately, these bubbles popped in 2000 and 2008, and those expected returns turned
into devastating losses for most.
Ref: Some Practical Advice

17. Which of the following is not part of security analysis?

a. Determining the factors that affect the value of the specific security
b. Determining the expected future returns for the specific security
c. Portfolio construction using mathematical and statistical models
d. Determining the appropriate allocation of funds across asset classes

Ans: c
Difficulty: Medium
Response: Security analysis involves a comprehensive approach to analyzing the
attractiveness of a particular company’s stock or bonds. A common approach considers
the impact of the overall economy, the company’s industry and competitors, and the
company itself. Asset allocation is used in financial planning, not security analysis.
Ref: Understanding the Investment Decision Process

18. Which statement best describes the current situation in global investing?

a. All U.S. stocks are also traded on foreign stock exchanges.

b. U.S. stocks account for 75% of the world’s stock market value.
c. All foreign stocks are traded in U.S. dollars.
d. About two-thirds of U.S. investors now own the securities of foreign companies.

Ans: d
Difficulty: Medium
Response: A global marketplace of round-the-clock investing opportunities has emerged
and many global companies now list their stocks on multiple foreign stock exchanges in
local currencies. Geographic diversification is now the norm, as most investors own the
stocks of companies from around the world.
Ref: Important Considerations in the Investment Decision Process for Today's Investors

19. Which of the following is not a contribution the internet has made to the field of
investments?

a. Investors can access information on companies and markets very easily.

b. Investors can place stock market orders quickly and inexpensively.
c. Individual investors now have access to information previously available only to
institutional investors.
d. Investors have much higher expected returns today because of the internet.

Ans: d
Difficulty: Easy
Response: The Internet has truly revolutionized the world of global investing, particularly
for individual investors. Online brokers offer cheap commissions, corporate information
is widely accessible, and securities can be bought and sold with a mouse click. Although
more individuals do invest directly today because of the internet, there is no correlation
between the Internet and better returns.
Ref: Important Considerations in the Investment Decision Process for Today's Investors

20. Which of the following best describes the relationship between individual and
institutional investors?

a. Individual investors have relatively small accounts; however, the combined value
of all their accounts is about two-thirds of the total value of the NYSE.
b. Relative to individual investors, institutional investors have much better access to
the managers of major public companies.
c. Individual investors sometimes invest directly and sometimes indirectly through
mutual funds and pension funds managed by large institutional investors.
d. Individual investors can never compete successfully with institutional investors.

Ans: c
Difficulty: Easy
Response: Although the Internet has largely driven the emergence of the individual
investor, institutional investors still hold the vast majority of the value of NYSE stocks,
largely through the mutual funds and pension funds that they manage on behalf of
individual investors.
Ref: Important Considerations in the Investment Decision Process for Today's Investors
Type: True False

1. The trade-off between risk and reward is one of the most important topics in
investments.

Ans: True
Ref: Some Practical Advice

2. The field of investments covers only marketable securities, not non-marketable

assets.

Ans: False
Ref: Establishing a Framework for Investing

3. Wealth should be evaluated and managed within the context of a portfolio, which
consists of the asset holdings of an investor.

Ans: True
Ref: Establishing a Framework for Investing

4. Investment bankers need security analysts to assist in the sale of new securities
and in the valuation of firms as possible merger or acquisition candidates.

Ans: True
Ref: The Importance of Studying Investments

5. All investors should invest in stocks, because historically stocks have provided
the highest return of all financial assets.

Ans: False
Ref: Some Practical Advice

6. The Chartered Financial Analyst (CFA®) designation is a professional

designation that helps people pursue careers in investments, similar to the
Certified Public Accountant (CPA®) designation for people pursuing careers in
accounting.

Ans: True
Ref: The Importance of Studying Investments

7. All investors have the same degree of risk aversion.

Ans: False
Ref: Some Practical Advice
8. Investments are made on the basis of future (ex ante) returns, rather than past (ex
post) returns.

Ans: True
Ref: Some Practical Advice

9. Even the best investors make mistakes.

Ans: True
Ref: Important Considerations in the Investment Decision Process for Today's Investors

10. New regulations have eliminated the possibility of unethical market behavior.

Ans: False
Ref: Ethics in Investing