Common Mistakes to Avoid
Watch out for these exam traps that candidates frequently miss on Analytical Methods questions:
Calculating NPV or IRR with wrong discount rate
Confusing nominal vs real returns
Forgetting to account for compounding frequency
Sample Practice Questions
An investment has a Net Present Value (NPV) of -$5,000. Based on this information, an investment adviser should:
C is correct. A negative NPV of -$5,000 means the present value of all cash flows is less than the initial investment, indicating the investment would destroy $5,000 of value. The investment rule is simple: accept projects with NPV > 0 and reject projects with NPV < 0.
A (Recommend because of positive cash flows) is incorrect because even if an investment generates cash flows, a negative NPV means those flows are insufficient to justify the cost. B (NPV measures total return) is incorrect because NPV measures value creation, not total return. D (Request additional info) is incorrect because NPV already incorporates all relevant information. No additional data is needed to make the rejection decision.
NPV is one of the most frequently tested analytical methods on the Series 65. Understanding the simple accept/reject rule is crucial: NPV > 0 = accept, NPV < 0 = reject, NPV = 0 = break even. This concept appears in capital budgeting questions and connects to discounted cash flow analysis. The exam often presents scenarios where candidates must distinguish between positive cash flows and positive value creation. An investment can have cash flows but still destroy value if those flows don't exceed the initial cost when discounted.
An investment's Internal Rate of Return (IRR) is 12%, and the investor's required rate of return is 10%. What should the investor do?
B is correct. When an investment's IRR (12%) exceeds the required rate of return (10%), the investment should be accepted because it generates returns above the investor's minimum threshold. The IRR decision rule is: accept if IRR > required return, reject if IRR < required return.
A (Reject because IRR exceeds required return) is incorrect because this is backwards. When IRR exceeds the required return, you should accept, not reject. C (Required return too low) is incorrect because the required return is the investor's personal hurdle rate; the question is whether the IRR clears it. D (Breaks even) is incorrect because the investment would only break even if IRR equaled the required return; here IRR is 2% higher, creating value.
IRR is tested on nearly every Series 65 exam, often alongside NPV questions. Understanding the IRR decision rule is essential: if the project's IRR exceeds your required return, it adds value. Remember that IRR is the discount rate where NPV = 0, and for bonds, IRR is the same as Yield to Maturity (YTM). The exam frequently tests whether you know to accept investments when IRR > required return. This concept is fundamental to capital budgeting and investment selection.
Using the Rule of 72, approximately how many years will it take for an investment to double at an 8% annual rate of return?
D is correct. The Rule of 72 provides a quick approximation for doubling time: Years to double = 72 ÷ interest rate = 72 ÷ 8 = 9 years. This mental math shortcut helps advisers quickly estimate compound growth without calculators.
A (6 years) is incorrect because this would require a 12% return (72 ÷ 12 = 6). B (8 years) is incorrect because it simply uses the interest rate itself rather than dividing 72 by the rate. C (12 years) is incorrect because this would result from a 6% return (72 ÷ 6 = 12).
The Rule of 72 appears regularly on the Series 65 as a practical time value of money application. It's a valuable client communication tool that allows you to quickly show clients how long their investments need to double at different rates. This rule also works in reverse: if you want money to double in 6 years, you need a 12% return (72 ÷ 6 = 12). The exam tests both directions: given a rate, find the time; given time, find the required rate. Remember: 72 divided by the rate gives years to double.
A portfolio has an annual return of 12% and a standard deviation of 18%. If returns are normally distributed, approximately what percentage of annual returns would fall between -6% and +30%?
A is correct. This question applies the 68-95-99.7 Rule for normal distributions. One standard deviation from the mean is 12% ± 18%, which gives a range of -6% to +30%. According to the rule, approximately 68% of values fall within ±1 standard deviation of the mean.
B (95%) is incorrect because 95% of values fall within ±2 standard deviations (12% ± 36%, or -24% to +48%). C (99.7%) is incorrect because this represents ±3 standard deviations (12% ± 54%, or -42% to +66%). D (100%) is incorrect because in a normal distribution, some extreme values always fall outside any finite range.
Standard deviation and the 68-95-99.7 Rule appear frequently on the Series 65, testing your understanding of risk measurement and probability. Standard deviation measures total risk (volatility), and knowing that 68% of returns fall within one standard deviation helps you assess portfolio risk. This concept connects to risk tolerance discussions with clients. A higher standard deviation means wider potential outcome ranges. The exam often presents scenarios requiring you to calculate ranges or identify the correct percentage for different standard deviation intervals.
Two assets have a correlation coefficient of -0.85. This indicates that:
A is correct. A correlation coefficient of -0.85 indicates a strong negative correlation, meaning the assets tend to move in opposite directions. When one asset increases in value, the other typically decreases. This negative correlation is highly valuable for diversification purposes.
B (Same direction) is incorrect because that describes positive correlation (+1 to 0), not negative correlation. C (No relationship) is incorrect because a correlation of 0 indicates no relationship; -0.85 shows a strong inverse relationship. D (Negative returns) is incorrect because correlation measures the relationship between returns, not whether returns themselves are positive or negative.
Correlation is a core portfolio management concept tested on every Series 65 exam. Understanding correlation helps you build diversified portfolios that reduce risk. The correlation coefficient ranges from -1 (perfect negative correlation, best for diversification) to +1 (perfect positive correlation, no diversification benefit). Correlation near -1 means combining these assets would significantly reduce portfolio volatility. This concept frequently appears in questions about Modern Portfolio Theory, asset allocation, and diversification benefits. Remember: negative correlation helps diversification.
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Access Free BetaWhich risk-adjusted performance measure would be MOST appropriate for comparing two well-diversified portfolios?
D is correct. The Treynor ratio is most appropriate for comparing well-diversified portfolios because it uses beta (systematic risk) in the denominator. For well-diversified portfolios, unsystematic risk has been eliminated, so only systematic risk matters. Treynor ratio = (Portfolio Return - Risk-Free Rate) ÷ Beta.
B (Sharpe ratio) is incorrect. While useful, Sharpe uses total risk (standard deviation) in the denominator, making it better for undiversified portfolios or standalone investments. A (Standard deviation) is incorrect because it measures total risk but isn't a risk-adjusted performance ratio. C (Coefficient of variation) is incorrect because while it's a relative risk measure, it doesn't adjust for the risk-free rate and isn't designed for performance comparison.
The distinction between Sharpe and Treynor ratios is heavily tested on the Series 65. The key is knowing when to use each: Sharpe ratio (uses standard deviation) for undiversified portfolios, Treynor ratio (uses beta) for well-diversified portfolios. Since well-diversified portfolios have eliminated unsystematic risk, only systematic risk (measured by beta) is relevant. This question tests whether you understand that diversification changes which risk measure is appropriate. Both ratios follow the same logic (higher values indicate better risk-adjusted performance) but they differ in their risk denominator.
A bond has a duration of 7 years. If interest rates increase by 1%, the bond's price will approximately:
C is correct. Duration measures a bond's price sensitivity to interest rate changes. A duration of 7 means the bond's price will change by approximately 7% for each 1% change in interest rates. Since interest rates and bond prices move inversely, a 1% increase in rates causes approximately a 7% decrease in price.
A (Increase by 7%) is incorrect because it ignores the inverse relationship between interest rates and bond prices. B (Increase by 1%) is incorrect because it doesn't account for duration. The price change isn't 1:1 with rate changes. D (Remain unchanged) is incorrect because bond prices always respond to interest rate changes; duration measures the magnitude of that response.
Duration is one of the most important bond concepts on the Series 65, appearing in multiple questions per exam. Understanding that duration predicts percentage price change for a given rate movement is essential for managing bond portfolios and explaining interest rate risk to clients. Longer duration means greater price sensitivity. A bond with duration of 10 is more volatile than one with duration of 3. This concept connects to the common mistake of forgetting to account for compounding frequency and the inverse relationship between rates and prices. Remember: duration in years × rate change in % = approximate price change in %.
A portfolio has an R-squared of 0.92 relative to the S&P 500. This indicates:
A is correct. R-squared (R²) represents the percentage of a portfolio's return movements that can be explained by movements in the benchmark. An R² of 0.92 means 92% of the portfolio's return variation is explained by the S&P 500, indicating the portfolio is well-diversified relative to that benchmark and its beta is reliable.
B (92% consists of S&P 500 stocks) is incorrect because R-squared measures statistical relationship, not portfolio composition. C (Returned 92% as much) is incorrect because R-squared doesn't measure relative returns. It measures how much return variation is explained by the benchmark. D (Correlation of 0.92) is incorrect because while related, correlation and R-squared are different: R² = correlation², so an R² of 0.92 indicates a correlation of approximately 0.96.
R-squared is frequently tested on the Series 65 as a measure of portfolio diversification and beta reliability. When R² > 0.70, the portfolio is considered well-diversified relative to the benchmark, and beta is meaningful. When R² < 0.70, beta may be unreliable because the portfolio doesn't track the benchmark closely. This concept helps determine whether systematic risk measures (like beta) are trustworthy for a given portfolio. The exam often tests whether you understand that high R-squared means the portfolio behaves similarly to its benchmark.
A mutual fund has a beta of 1.4. If the market increases by 10%, the fund would be expected to:
B is correct. Beta measures systematic risk relative to the market. A beta of 1.4 means the fund is 40% more volatile than the market. When the market increases by 10%, a fund with beta of 1.4 would be expected to increase by 14% (10% × 1.4 = 14%).
A (Increase by 10%) is incorrect because that would be the expected return for a beta of 1.0 (market-level volatility). C (Increase by 1.4%) is incorrect because it uses beta as the return rather than as a multiplier. D (Decrease by 4%) is incorrect because when the market rises, a positive beta fund also rises (negative beta would move opposite to the market, but that's rare).
Beta appears on virtually every Series 65 exam and is fundamental to understanding systematic risk and the Capital Asset Pricing Model (CAPM). Beta > 1.0 indicates higher volatility than the market (aggressive), beta = 1.0 means market-level volatility, and beta < 1.0 means lower volatility (defensive). This concept is crucial for portfolio construction and client suitability. Aggressive clients might accept high-beta funds, while conservative clients prefer low-beta investments. The exam frequently tests whether you can calculate expected returns based on beta and market movements. Remember: beta only measures systematic risk, not total risk.
An investment adviser is comparing three investments with different levels of risk and return. Which measure would allow the BEST comparison of risk per unit of return?
D is correct. The coefficient of variation (CV) is calculated as standard deviation ÷ mean return, providing a relative risk measure that allows comparison of investments with different return levels. A lower CV indicates less risk per unit of return, making it ideal for comparing investments of different sizes and return profiles.
A (Standard deviation) is incorrect because it's an absolute risk measure that doesn't account for different return levels. A high standard deviation might be acceptable for a high-return investment but excessive for a low-return one. B (Beta) is incorrect because it only measures systematic risk relative to the market, not total risk per unit of return. C (R-squared) is incorrect because it measures how much of a portfolio's variation is explained by a benchmark, not risk-adjusted return comparison.
Coefficient of variation is tested on the Series 65 as a practical tool for comparing investments with different risk and return profiles. Unlike standard deviation (which is absolute), CV is a relative measure that adjusts risk for the level of return. This makes it particularly useful when comparing, for example, a high-return/high-risk emerging market fund with a low-return/low-risk bond fund. Lower CV values indicate better risk-adjusted returns. This concept often appears in questions about comparing multiple investment options with varying characteristics. Remember: CV = risk per unit of return, making apples-to-apples comparisons possible.
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